THE 

ARTHUR  YOUNG 

ACCOUNTING 

COLLECTION 


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ACCOUNTS 

IN 

THEORY  AND  PRACTICE 


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ACCOUNTS 

IN 

THEORY  AND    PRACTICE 

PRIISCIPLES 


BY 
EARL  A.  SALIERS,  Ph.D. 

ArtrtlSTANT   PB0FE88OR  OF   ACCOUNTING   IN  THE   SHEFFIELD  SCIENTIFIC    SCHOOL 
OF   YALE    UNIVERSITY 


First  Edition 


McGRAW-HILL  BOOK  COMPANY,  Inc 

NEW  YORK:    239  WEST  39TH  STREET 

LONDON:    6  &  8  BOUVERIE  ST.,  E.  C.  4 

1920 


57159 


Copyright,  1920,  by  the 
McGraw-Hill  Book  Company,  Inc. 


THE     MXPIiE     FHE8S     T  O  X  K    I>A 


Bus.  AdmiiB. 
Library 


HF 

5625 

SI6 


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€.  D.  V.  S. 

L.   J.   S. 
M.  D.  S. 


PREFACE 

The  purpose  of  this  book  is  to  afford  a  first  course  in  the 
principles  of  accounts.  Although  it  is  intended  primarily  as  a 
first  semester  text  it  is  the  author's  hope  that  it  will  prove  useful 
in  wider  fields.  An  attempt  has  been  made  to  work  out  an 
effective  combination  of  theoretical  discussion  and  practical 
application.  The  author  realizes  that  every  individual  has  his 
own  ideas  about  the  proper  sequence  of  subject  matter.  An 
attempt  has  therefore  been  made  to  arrange  the  material  so  that, 
if  desirable,  the  order  of  study  may  be  varied  somewhat,  and 
possibly  some  parts  omitted, 
vx  For  several  years  the  author  has  followed  the  plan  of  having  his 

\v.  students  construct  their  practice  sets  from  ordinary  commercial 
ledger  and  journal  paper.  Such  alterations  in  rulings  can  be 
made  as  may  be  necessary  to  make  these  blank  forms  conform  to 
the  requirements  of  the  text.     Such  forms  as  are  not  readily 

,  obtainable  should  be  drawn  upon  blank  sheets  of  paper.  This 
plan  throws  the  learner  upon  his  own  resources,  teaches  him  that 
forms  are  to  be  varied  to  meet  requirements,  and  is  at  once  simple 
and  economical.  All  forms  are  shown  in  the  text.  These  will 
serve  as  models  in  the  preparation  of  the  practice  sets.  The 
instructor  should  arrange  to  have  in  readiness  a  supply  of  ordi- 
nary two-column  journal  paper  and  ordinary  ledger  paper;  also, 

^  if  possible,  a  supply  of  columnar  paper  from  which  to  construct 
■^  columnar  journals,  voucher  registers,  and  so  on.  For  this  pur- 
pose ordinary  trial  balance  paper,  which  contains  twenty-four 
columns,  may  be  used.  Accountants'  analysis  paper  will  serve 
equally  well.  Reference  to  practice  chapters  VII,  VIII,  XV 
(same  set  continued),  XVIII,  XX,  and  to  chapter  XXXIV  will 
indicate  the  materials  needed.  Work  on  practice  chapter  VII 
may  be  begun  as  soon  as  desirable,  but  it  is  suggested  that  it  be 
started  after  the  study  of  chapter  III  has  been  completed  (See 
page  21).  For  reference  purposes  a  bibliography  has  been  in- 
serted at  the  end  of  each  of  the  six  parts  of  the  book. 

The  author  is  planning  a  second  volume  which  will  treat  of  the 
more  complicated  aspects  of  general  accounting  procedure  such 
as    valuation,    ledger    analysis,    consolidations,    branch    house 

vii 


vm  PREFACE 

accounts,  and  realization  and  liquidation.  It  is  his  belief  that  the 
further  standardization  of  accounting  courses  will  be  along  the 
lines  followed  in  the  present  and  proposed  volumes,  i.e.,  that 
the  first  half-year's  work  should  be  a  drill  in  the  theory  and 
practice  of  accounts  with  emphasis  on  fundamental  principles, 
and  that  the  second  half-year's  work  should  include  a  thorough 
study  of  the  more  complicated  aspects  of  general  procedure,  such 
as  those  suggested  above. 

Each  of  the  six  parts  of  this  book  is  of  about  the  proper  length 
for  review  and  examination  purposes.  To  facilitate  review  work 
an  appendix  containing  a  series  of  questions  on  each  chapter  has 
been  added. 

For  suggestions  and  criticisms  the  author  is  under  obligation 
to  many  individuals,  including  his  students.  He  is  especially 
indebted  to  Mr.  J.  D.  Hauslein  of  Yale  University  and  to  Mr. 
James  J.  Markham,  Controller  of  Sargent  and  Company,  New 
Haven,  Conn.  Professor  A.  L.  Bishop  of  the  Sheffield  Scientific 
School  of  Yale  University  has  made  useful  suggestions  regarding 
the  arrangement  of  materials.  Mr.  K.  J.  Ralph  has  made  certain 
corrections  in  the  chapters  on  manufacturing  accounting.  The 
author  nevertheless  assumes  full  responsibility  for  any  errors 
that  still  exist  and  he  will  consider  it  a  favor  to  receive  such 
corrections  and  criticisms  as  readers  may  wish  to  offer. 

Earl  A.  Saliers. 
New  Haven,  Conn., 
May  24,  1920. 


CONTENTS 

Page 

Preface VII 

PART  I 

Fundamental  Principles 
Chapter 

I.  The  Purpose  of  Accounts 1 

il.  Recording  Financial  Transactions 8 

III.  Recording  Financial  Transactions  (Continued) 14 

IV.  The  Functional  Classification  of  Transactions      22 

V.  Functional  Classification  of  Transactions  Illustrated  ...  29 

VI.  Interpretation  of  Ledger  Accounts 35 

VII.  Recording  Financial  Transactions — Practice 44 

VIII.  Recording  Financial  Transactions — Practice 55 

IX.  The  Theory  of  Accruals  and  of  Deferred  Charges    ....  59 

X.  Accruals  and  Deferred  Charges — Practice 65 

XI.  Depreciation,  Bad  Debts,  and  Valuation  Reserves      ...  69 
XII.  Depreciation,  Bad  Debts,  and  Valuation  Reserves — Prac- 
tice      81 

PART  II 
Partnership  Accounting 

XIII.  The  Partnership — Special  Considerations      87 

XIV.  Theory  of  Partnership  Accounting 92 

XV.  Partnership  Accounting — Practice      . 101 

PART  III 
Expansion  of  Accounting  Records 

XVI.  Subordinate  Ledgers  and  Controlling  Accounts 105 

XVII.  Accounting  for  Petty  Cash  Payments 114 

XVIII.  Controlling  Accounts  and  Imprest  System — Practice      .    .119 

XIX.  The  Voucher  Register 126 

XX.  The  Voucher  Register— Practice 129 

XXI.  The  Private  Ledger 139 

XXII.  The  Private  Ledger— Practice 142 

PART  IV 
Corporation  Accounting 

XXIII.  The  Corporation — Special  Considerations 145 

XXIV.  The  Corporation — Opening  Corporation  Books        ....  155 
XXV.  Proprietorship  and  Partnership  Incorporated 159 

XXVI.  The  Corporation — Accounting  for  Bond  Lssues 167 

XXVII.  The  Corporation — Redemption  of  Bonds 173 

XVIII.  The  Corporation — Routine  Accounting  Procedure  ....  180 

XXIX.  The  Corporation— Practice 186 

ix 


X  CONTENTS 

PART  V 
Financial  Statements 

Chapteh  Page 

XXX.  Construction  and  Interpretation  of  the  Income  Statement  191 

XXXI.  The  Income  Statement  Illustrated      202 

XXXII.  Construction  and  Interpretation  of  the  Balance  Sheet    .    .  208 

XXXIII.  Construction   and   Interpretation   of  the   Balance   Sheet 

{Continued)      • 218 

PART  VI 
Special  Applications  of  Principles 

XXXIV.  Department  Accounting       225 

XXXV.  Department  Accounting — Practice 231 

XXXVI.  Department  Accounting — Practice  (Continued) 247 

XXXVII.  Manufacturing  Accounting 251 

XXXVIII.  Manufacturing  Accounting  {Continued) 260 

XXXIX.  Manufacturing  Accounting — Practice 269 

XL.  Relation  of  Accounting  to  Management 273 

XLI.  Graphic  Charts 281 

Appendix   A 288 

Index 297 


ACCOUNTS  IN  THEORY  AND  PRACTICE 

PART  I 

FUNDAMENTAL  PRINCIPLES 


CHAPTER  I 
THE  PURPOSE  OF  ACCOUNTS 

Accounting  a  Branch  of  Economics. — Accounting  is  an  applied 
branch  of  the  science  of  economics.  Economics  treats  of  the 
production  and  distribution  of  wealth.  The  economist  usually 
employs  these  words  in  a  comprehensive  sense,  as  when  speaking 
of  the  production  of  wealth  in  the  United  States  and  its  succeed- 
ing distribution  among  one  hundred  million  or  more  inhabitants 
of  the  country.  The  economist  studies  the  various  agencies 
which  facilitate  or  impede  the  production  of  wealth,  the  effects, 
for  example,  of  legislation,  legal  and  natural  monopolies,  fran- 
chises and  special  privileges,  labor  unions,  government  ownership 
of  railroads,  commission  control,  and  so  on.  He  encourages 
the  introduction  of  reforms  which  he  believes  will  increase  pro- 
ductivity or  lessen  waste.  As  Adam  Smith,  more  than  one  hun- 
dred years  ago,  pointed  out  the  benefits  of  division  of  labor,  so  all 
economists  since  his  time  have  been  debating  the  pros  and  cons 
of  those  questions  which  relate  to  the  productivity  of  wealth. 

Economists  attempt  to  discover  the  principles  which  govern 
the  distribution  of  wealth  among  the  inhabitants  of  the  country 
after  it  has  been  produced.  Some  of  it  goes  to  the  laborer,  some 
to  the  capitalist,  some  to  tha  landlord.  Whether  the  present 
system  of  industry,  as  established  by  law  and  custom,  secures 
the  most  equitable  distribution  of  wealth  is  a  disputed  question, 
beyond  the  province  of  this  book.  Production  and  distribution 
of  wealth,  all  will  agree,  require  the  expenditure  of  the  energy 
and  time  of  the  inhabitants  of  a  nation  and  consequently  deserve 
the  careful  attention  of  those  who  study  them  and,  if  possible, 
improve  them  by  introducing  scientific  methods  of  procedure. 

1 


2  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Scientific  methods  require  adequate  records.  Such  records  enable 
one  to  see  readily  what  has  been  accomplished  and  supply  data 
valuable  in  making  future  improvements. 

Modern  Methods  of  Production. — The  past  century  has  wit- 
nessed a  remarkable  growth  in  the  productive  capacity  of  most 
countries.  This  growth  has  been  accompanied  by  such  altera- 
tions in  the  organization  of  industry  as  have  been  necessary 
to  cope  with  the  new  methods  of  production  and  distribution. 
Along  with  the  increase  in  wealth  made  possible  by  machine 
methods,  division  of  labor,  etc.,  there  has  gone  a  concentration 
of  that  wealth,  if  not  in  the  ownership  of  a  comparatively  few 
persons,  at  least  in  their  control.  The  man  who,  had  he  lived  a 
century  ago,  would  have  employed  his  limited  means  in  con- 
structing a  workshop  in  which  he  would  have  become  the  master 
workman  and  surrounded  himself  with  a  few  journeymen  and 
apprentices,  is  likely,  today,  to  become  one  of  several  hundred 
or  several  thousand  stockholders  or  bondholders  in  a  corporation 
with  assets  totaling  millions  of  dollars  and  employees  numbered 
in  thousands. 

Under  the  old  conditions,  when  each  capitalist  was  also  a 
workman  and  was  enabled  to  supervise  personally  all  the  details 
of  his  small  enterprise,  there  was  no  occasion  for  any  very  com- 
plicated system  of  recording  transactions.  Markets  were  not  as 
wide  and  competition  was  not  as  keen  as  they  are  today.  The 
credit  system,  which  underlies  nearly  all  modern  enterprise, 
was  still  in  its  infancy.  Railroads,  the  telegraph,  the  telephone, 
the  steamship,  and  those  conveniences  which,  by  "abridging 
distance,"  facilitate  commercial  intercourse  over  long  distances, 
were  unknown.  Commercial  organization  was  less  complicated. 
Everything  progressed  at  a  slower  pace,  and  there  was  not  the 
pressing  need  for  accurate  information  as  to  the  results  so  shortly 
after  their  consummation  as  there  is  today.  Merchants  sent 
vessels  on  cruises  lasting  two  or  three  years  and  awaited  patiently 
the  outcome  of  their  ventures.  Today  they  receive  daily  reports 
by  wireless  of  the  progress  of  ocean  liners.  They  keep  in  hourly 
connection  with  the  great  markets  of  distant  cities  where  prices 
are  made  and  telegraphed  to  the  whole  world.  They  demand 
daily  progress  reports  from  their  business  managers. 

The  Information  Needed. — These  conditions  make  accurate 
and  timely  information  essential  to  success.  To  illustrate,  the 
manager  of  a  department  store  must  so  systematize  his  affairs 


THE  PURPOSE  OF  ACCOUNTS  3 

that  he  can  not  only  tell  whether  his  store  as  a  whole  is  making  a 
profit,  but  he  must  know  also  the  standing  of  each  department. 
A  manufacturer  must  not  merely  know  at  the  close  of  the  year 
that  he  has  made  a  profit;  he  requires  specific  information  as  to 
the  cost  of  each  commodity  that  he  manufactures,  not  annually 
but  monthly  or  weekly,  if  he  desires  to  operate  on  an  efficient 
basis.  The  president  of  the  Bethlehem  Steel  Company  requires 
a  complete  report  on  each  month's  operations  not  later  than  the 
fifth  day  of  the  succeeding  month. 

There  are  a  number  of  features  of  modern  business  organiza- 
tion that  make  imperative  the  demand  for  accurate  records. 
Chief  among  these  are : 

(a)  Price  making  and  Competition. 

(b)  The  Credit  System. 

(c)  Management. 

(d)  Valuation. 
(«)  Taxation. 
(/)  Investments. 

ig)  Profits — Determination  and  Division. 

Price  Making  and  Competition. — Price  making  and  competi- 
tion are  two  inseparable  factors  in  business.  Competition  usu- 
ally brings  vigorous  and  healthful  activity  into  industry  and 
commerce.  But  upon  some  enterprises  its  effects  are  destruc- 
tive, especially  upon  those  which  are  without  any  adequate  knowl- 
edge of  their  costs  and  expenses  and  which  consequently  are 
unable  to  place  prices  upon  their  products  except  by  adopting 
the  prices  set  by  their  competitors,  or  by  attempting  to  underbid 
their  competitors.  The  evils  of  the  competitive  system  are 
greater  than  the  benefits,  for  concerns  so  situated.  If  commodi- 
ties are  selhng  at  only  a  fair  profit  it  is  dangerous  policy  to  lower 
prices  without  compensating  for  the  lowered  selling  price  through 
economies  or  increased  efficiency  in  some  or  all  departments. 
When  adequate  accounts  are  kept  they  furnish  the  danger  sig- 
nals to  the  manager,  showing  him  the  limits  beyond  which  he 
cannot  safely  go  in  his  policy  of  price  reduction.  They  also 
show  him  along  what  lines  the  greatest  reductions  can  be  made, 
and  may  suggest  lines  which  it  will  be  well  to  discontinue 
entirely. 

With  an  adequate  system  of  accounts  an  enterprise  with  an 
average  outlook  should  weather  the  competitive  stress  without 
difficulty;  much  more  easily  indeed,  than    a  company  better 


4  ACCOUNTS  IN  THEORY  AND  PRACTICE 

favored  by  natural  conditions  but  lacking  an  adequate  system  of 
accounts. 

The  Credit  System. — A  large  percentage  of  business  is  done  on 
a  credit  basis.  Credit  requires  the  reliance  of  one  person  or 
concern  upon  another  person  or  concern.  Character  lies  at  the 
foundation  of  this  system,  but  capacity  and  capital  are  also 
essential  to  it.  Not  only  crimes  and  frauds  but  unintentional 
errors  as  well  must  be  guarded  against,  to  make  the  credit 
system  most  useful.  Credit  requires  the  use  of  various  business 
papers,  notes,  drafts,  acceptances,  stocks,  bonds,  mortgages, 
etc.,  which  must  be  properly  filed  and  recorded  and  their  bearing 
and  influence  shown. 

Credit  is  subject  to  misuse.  Some  take  advantage  of  discounts 
to  which  they  are  not  entitled.  Some  overbuy.  Others  grant 
credit  to  those  who  do  not  merit  it,  and  so  on.  There  is  a  limit 
beyond  which  the  extension  of  credit  becomes  dangerous.  Such 
over-extensions  lead  to  panics  and  commercial  crises.  Although 
accounting  cannot  remedy  all  of  the  evils  of  the  credit  system  it 
aids  in  the  correct  observance  of  its  principles,  and  it  furnishes 
information  which  helps  to  ameliorate  the  evils  mentioned. 

Management. — Management  begins  with  the  promotion  of  an 
enterprise,  guides  its  operations  as  a  working  establishment,  and 
continues  its  supervision  until  dissolution  ends  its  affairs.  High 
salaries  are  paid  to  secure  efficient  managers.  Efficient  managers 
demand  the  fullest  information  concerning  the  plants  they  super- 
intend. They  require  daily,  weekly,  monthly  and  yearly  reports 
showing  operating  results  in  all  departments.  They  also  require 
comparative  statements  illustrating  changes  in  costs,  selling 
prices,  profits,  etc.,  over  periods  of  several  years'  duration.  These 
cannot  be  supplied  unless  adequate  accounts  are  kept. 

The  manager  makes  great  and  constant  demands  upon  the 
accounting  department.  The  relationship  which  the  business 
bears  to  the  state,  to  other  concerns  and  to  individuals  who  do 
business  with  it,  to  banks,  and  to  the  purchasers  of  its  securities, 
although  important,  is  in  a  sense  intermittent,  occupying  the 
attention  of  both  parties  occasionally,  and  then  lapsing  into  a 
more  or  less  static  condition  requiring  little  attention  for  a  time. 
But  the  manager  remains  constantly  at  the  helm  and  for  his 
benefit  above  all  others  the  accounts  must  be  kept  properly.^ 

^  For  a  more  detailed  study  of  the  relation  of  accounting  to  management 
see  Chapter  XL. 


THE  PURPOSE  OF  ACCOUNTS  5 

Valuation. — The  property  of  a  concern  requires  frequent  valua- 
tions for  various  purposes,  for  reasons  which  the  student  will 
understand  as  he  proceeds.  Variations  in  the  value  of  a  concern's 
property  influence  definitely  its  financial  status.  Allowance  for 
these  changes  must  be  made  in  the  accounts.  Among  the  chief 
purposes  of  valuations,  in  addition  to  the  one  mentioned,  are: 
to  aid  the  state  in  levying  taxes,  to  determine  proper  charges 
for  service  rendered  to  the  public,  and  to  determine  values  for 
purposes  of  sale. 

In  recent  years  the  government,  federal  and  state,  has  done 
very  extensive  work  along  this  line,  both  for  purposes  of  taxation 
and  for  rate-making.  Public  utilities,  i.e.,  railroads,  street 
railways,  water  works  and  other  establishments  which  supply 
services  to  the  general  public  on  a  non-competitive  basis,  have, 
in  this  respect,  received  the  state's  special  attention.  It  is  out 
of  our  province  to  attempt  a  complete  explanation  of  the  reasons 
for  this  innovation,  except  to  note  that  the  work  is  usually  done 
to  secure  a  basis  for  rate-making  or  taxation,  or  both.  If  a 
company  has  kept  proper  accounts  the  work  of  valuation  is 
greatly  simplified  and  expedited. 

Taxation. — Taxation  was  mentioned  as  a  purpose  of  valuations, 
but  whether  valuations  are  made  or  not,  taxes  must  be  paid,  if 
not  on  the  basis  of  a  recent  valuation  then  on  the  basis  of  other 
available  data.  Good  accounting  records  are  indispensible  to 
an  accurate  history  of  the  changes  in  the  value  of  property. 

The  adoption  of  the  income  tax  by  the  federal  government  and 
some  state  governments  as  the  chief  means  of  securing  revenue 
has  given  a  great  impetus  to  the  keeping  of  correct  accounts. 
Nothing  else  has  done  so  much  to  create  a  demand  for  the  services 
of  expert  accountants. 

Investments. — Investing  is  a  corollary  of  modern  large  scale 
enterprise.  Our  present  system  of  concentration  of  wealth  under 
the  control  of  a  comparatively  few  men — officials  and  directors 
of  corporations — implies  that  the  great  majority  of  the  people 
who  become  interested  in  these  corporations  do  so  as  investors 
rather  than  as  direct  participants  in  the  management  of  the 
company.  The  amount  of  the  country's  wealth  is  constantly 
increasing  and  is  being  invested  by  individuals,  trust  companies, 
savings  banks,  insurance  companies,  and  other  organizations 
which  in  one  way  or  another  come  into  the  possession  of  funds 
not  required  for  their  own  immediate  use. 


6  ACCOUNTS  IN  THEORY  AND  PRACTICE 

All  who  invest  their  money  in  enterprises  the  management  and 
control  of  which  rest  in  the  hands  of  others  must  have  accurate 
reports  and  information  concerning  the  financial  status  of  these 
enterprises.  As  the  science  of  investments  becomes  better  under- 
stood the  securities  of  companies  which  tolerate  any  but  the 
most  efficient  methods  of  accounts  and  control  will  go  begging 
for  a  market,  while  those  which  give  to  the  investing  public  the 
most  up-to-date  and  accurate  information  will  secure  additional 
funds  with  greatest  ease.  The  admirable  policy  of  publicity 
adopted  by  some  of  our  largest  corporations,  such  as  the 
United  States  Steel  Corporation  and  the  International  Har- 
vester Company,  is  made  possible  only  by  adequate  account- 
ing systems. 

Profits — Determination  and  Distribution. — The  purpose  of  all 
business  undertakings,  excepting  those  of  an  eleemosynary  char- 
acter, is  to  make  a  profit.  Profit  is  an  increase  in  wealth  secured 
through  increased  value  given  to  materials  through  manufacture 
or  through  increased  value  given  to  commodities  by  transporting 
them  to  suitable  points  and  distributing  them  to  consumers,  or  by 
providing  needed  services  of  one  kind  or  another.  When,  how- 
ever, the  equipment,  supplies  and  other  paraphernalia  of  manu- 
facture and  commerce  become  costly  and  complex  it  is  difficult 
to  determine  what  profit  is  made  in  a  given  period,  say  a  month 
or  a  year.  The  success  and  justice  of  the  modern  system  of 
production  and  distribution  depends  upon  the  accurate  deter- 
mination of  profits.  Without  this,  taxes,  wages,  prices,  etc., 
are  certain  to  be  more  or  less  prejudicial  to  some  interests  and 
favorable  to  others.  The  government  taxes  corporations  on 
their  net  profits.  If  one  corporation  overstates  its  profits  and 
another  understates  its  profits,  their  taxes  are  too  great  and  too 
small  respectively.  Prices  must  be  fixed  at  such  a  point  above 
costs  as  will  allow  an  adequate  percentage  of  profits.  If  costs 
and  profits  cannot  be  determined  the  work  of  pricing  will  be 
indefinite  and  hazardous. 

Profits  are  usually  distributed  among  claimants  who  possess 
varying  privileges  respecting  them.  The  proportion  of  the  profits 
which  each  claimant  may  receive  is  not  usually  a  fixed  one,  but 
varies  with  the  total  amount  of  the  profit.  Consequently 
this  aspect  of  the  distribution  of  wealth  rests  directly  upon  sound 
accounting,  without  which  injustice  is  certain  to  occur  in  the 
division  of  profits. 


THE  PURPOSE  OF  ACCOUNTS  7 

Summary. — We  have  shown  how  seven  great  phases  of  modern 
industriahsm  are  directly  dependent  upon  the  science  of  account- 
ing. Every  student  of  business  methods,  therefore,  will  possess 
a  more  or  less  incomplete  foundation  for  his  approach  to  the 
problems  that  confront  him  unless  he  has  first  secured  a  mastery 
of  the  principles  of  this  science.  It  is  the  purpose  of  this  book 
to  afford  such  knowledge  of  accounts  as  a  fair  amount  of  study 
should  secure.  Furthermore  it  will  be  our  purpose  to  subordinate 
the  consideration  of  unimporcant  detail  and  form  to  the  con- 
sideration of  those  principles  which,  with  variation  as  to  details, 
apply  most  universally. 


CHAPTER  II 
RECORDING  FINANCIAL  TRANSACTIONS 

Cash  and  Credit  Transactions. — Financial  transactions  are  of 
two  kinds — those  based  on  credit  and  those  based  on  cash. 
Credit  as  an  aid  to  business  has  become  increasingly  important. 
At  present  about  nineteen-twentieths  of  the  world's  trade  is 
carried  on  with  its  aid.  Cash  transactions  are  limited  largely 
to  the  retail  trade.  Even  here  credit  sales  tend  to  displace  cash 
sales,  and  in  many  lines  of  retailing  credit  sales  greatly  exceed 
cash  sales. 

Advantages  of  Credit. — There  are  reasons  for  the  increasing 
employment  of  credit.  Among  these  are  its  convenience, 
economy,  and  value  as  a  substitute  for  cash.  Its  advantages 
outweigh  its  disadvantages.  Although  dangerous  when  carelessly 
employed,  the  evil  consequences  of  its  misuse  can  be  minimized 
by  taking  proper  steps  to  regulate  and  protect  the  credit  system. 

Merchants,  bankers  and  manufacturers  employ  both  credit 
and  cash  and  they  receive  and  disburse  cash.  Cash  and  credit 
are  the  media  of  business  transactions.  Cash  takes  the  form 
of  paper  money,  coin,  and  checks.  Sometimes  credit  has  no 
documentary  evidence;  sometimes  it  is  more  or  less  formally 
represented  by  a  variety  of  written  or  printed  documents, 
collectively  known  as  credit  instruments. 

Two  Kinds  of  Transactions. — Cash  and  credit  are  means  to 
an  end — the  harmonious  transfer  of  commodities  and  services 
from  those  who  provide  them  to  those  who  consume  them.  If, 
when  purchasing  clothing,  we  pay  cash,  we  employ  it  for  an  end — 
the  satisfaction  of  a  need.  But  if  we  do  not  pay  immediately 
we  accomplish  the  same  end  by-  a  different  means,  namely, 
credit.  In  either  case  the  transaction  costs  us  a  given  amount; 
but  in  the  one  instance  we  assume  the  burden  by  surrendering 
cash,  while  in  the  other  we  assume  the  burden  by  pledging  to 
pay  in  the  future.  Although  unlike  in  form,  these  two  classes 
of  transactions  have  a  like  effect  upon  our  wealth.  If  we  pay 
c^h  our  liability  ceases  the  same  instant  in  which  we  incur  it 

8 


RECORDING  FINANCIAL  TRANSACTIONS 


and  the  transaction  is  completed.     If  we  secure  credit  we  incur 
a  liability  which  must  be  paid  later  in  cash  or  its  equivalent. 

Recording  Transactions. — Transactions  being  thus  funda- 
mentally simple  may  be  recorded  by  the  application  of  principles 
equally  simple.  Primitive  merchants  kept  crude  records  upon 
which  they  "chalked  up,"  or  charged,  those  who  obtained  credit 
when  purchasing  from  them.  This  they  did  by  writing  the 
names  of  their  customers  and  entering  beside  or  below  them  the 
amount  and  terms  of  the  sale.  As  the  result  of  experience, 
the  primitive  forms  were  gradually  supplanted  by  improved 
ones,  until  it  grew  customary  to  record  every  transaction  by 
means  of  a  double  entry.  Thus  a  sale  of  goods  for  cash,  $100, 
was  recorded  as  follows, 

Cash $100.00 

To  Sales $100.00 

On  the  other  hand  a  sale  of  goods  on  credit  to  a  customer,  John 
Allen,  was  recorded  thus, 


John  Allen $100 .  00 

To  Sales 


$100.00 


By  placing  "cash,"  or  the  name  of  the  person  "charged," 
above,  and  a  little  to  the  left  of  the  name  of  the  commodity 
sold  we  secure  a  classification,  which  conveniently  separates 
cash,  or  the  name  of  the  person  charged,  from  the  name  of  the 
thing  sold.  This  form,  however,  is  not  absolute,  but  is  adhered 
to  only  so  long  as  it  is  impossible  to  contrive  a  better  one.  When 
the  merchant's  transactions  grew  sufficiently  numerous  to  war- 
rant further  refinements  a  specially  ruled  book,  the  Journal, 
was  made  to  receive  these  entries,  thus. 

Journal 


Df'bit 

Credit 

Date 

Explanations 

F 

Amounts 

Amounts 

Cash 

100.00 
100.00 

To  Sales 

100.00 

John  Allen 

To  Sales 

100  00 

Naturally  the  Journal  differed  somewhat  in  form  in  different 


10  ACCOUNTS  IN  THEORY  AND  PRACTICE 

times  and  places.  Probably  its  development  into  the  form  shown 
above  was  a  slow  one.  Any  record  may  vary  somewhat  in  form, 
depending  upon  the  purpose  for  which  it  is  intended  and  the 
wishes  of  its  designer. 

Function  of  the  Journal. — The  Journal  provides  a  convenient 
chronological  record  of  transactions,  that  is,  one  in  which  they 
are  entered  as  soon  as  convenient  after  their  occurrence  and  in 
the  order  of  their  occurrence.  Any  transaction  may  be  recorded 
in  the  Journal.  Before  it  is  recorded  it  must  be  split  up  into  its 
two  essential  elements,  one  a  debit  or  left  side  Journal  entry,  the 
other  a  credit  or  right  side  Journal  entry.  That  element  of  the 
transaction  which  is  placed  on  the  left  is  the  charge  or  debit 
element,  and  that  element  which  is  placed  to  the  right  is  the 
credit  element.  In  the  first  transaction  entered  in  the  Journal 
above,  cash  is  charged  or  debited  $100.  In  the  second  entry 
John  Allen  is  charged  $100  and  merchandise  or  sales  is  credited 
$100. 

Meaning  of  Debit  and  Credit. — As  employed  here  the  words 
debit  and  credit  possess  a  technical  meaning  which  must  not  be 
confused  with  the  words  debit  and  credit  as  ordinarily  employed. 
Moreover  each  has  a  double  and  apparently  contradictory  use. 
Thus  we  say  that  an  item  is  debited  when  it  is  placed  to  the  left 
in  the  Journal.  Such  a  debited  item,  however,  may  indicate 
either  (a)  wealth  received,  or  (6)  losses  or  expenses  incurred. 
Likewise  an  item  credited,  that  is,  placed  to  the  right,  in  the 
Journal,  represents  (a)  debts  incurred,  or  (6)  wealth  surrendered, 
or  (c)  gains  made. 

Debits  and  Credits  Illustrated. — As  an  illustration  of  the  fore- 
going propositions,  consider  the  following  journal  entries: 

Case  I 

Cash  {i.e.,  wealth  received) $    100.00 

To  Sales $  100.00 

To  record  a  sale  of  merchandise  for  cash. 

Rent  (i.e.,  expense  incurred) $      30 .  00 

To  Cash $     30.00 

To  record  payment  of  rent  in  cash. 

Profit  and  Loss  (i.e.,  loss  incurred) $  1,000.00 

To  Building  (destroyed) $1,000.00 

To  record  loss  resulting  from  destruction  of  building  by  fire. 

By  reference  to  the  debit  or  left  hand  items  above  we  can  for- 
mulate the  rule,  debit  or  charge  wealth  received,  and  expenses 


RECORDING  FINANCIAL  TRANSACTIONS  1 1 

and  losses  incurred,  this  having  become,  by  custom,  the  method 
of  indicating  these  items. 

Case  II. 

Purchases $200.00 

To  John  Allen  (i.e.,  debt  incurred) $200 .  00 

To  record  a  purchase  of  merchandise  from  John  Allen. 

John  Allen $100.00 

To  Sales  (i.e.,  wealth  surrendered) $100 .  00 

To  record  a  sale  of  merchandise  to  John  Allen. 

The  full  meaning  of  this  last  entry,  assuming  that  the  goods  sold  cost  $90 
may  be  expressed  thus: 

John  Allen $100.00 

To  Sales  (i.e.,  wealth  surrendered  at  cost) $90.00 

Profit  and  Loss  (i.e.,  gains  made) 10.00 

To  record  sale  of  merchandise  to  John  Allen,  showing  selling 
price  analyzed  to  indicate  profit. 

By  reference  to  the  credit  or  right  hand  items  above  we  can 
formulate  the  rule,  credit  debts  incurred,  wealth  surrendered 
and  profits  made,  this  having  become,  by  custom,  the  mode  of 
showing  these  items. 

Rules  for  Debits  and  Credits. — The  foregoing  will  help  us  to 
comprehend  that  the  results  of  every  transaction  resolve  them- 
selves into  two  or  more  of  the  following: 

1.  Wealth  received      ^ 

2.  Expenses  incurred   [  which  are  debits. 

3.  Loss  incurred  J 

4.  Debts  incurred  "i 

5.  Wealth  surrendered     [  which  are  credits. 

6.  Profit  made  J 

Therefore,  recognizing  the  real  nature  of  transactions,  we  can 
formulate  the  rules  for  debit  and  credit.     These  are  for  debits : 

1.  Debit  wealth  received  by  us. 

2.  Debit  expenses  incurred  by  us. 

3.  Debit  losses  incurred  by  us. 

and  for  credits: 

4.  Credit  wealth  surrendered  by  us. 

5.  Credit  debts  incurred  by  us. 

6.  Credit  profits  made  by  us. 

Illustrations  of  Rules  for  Debits  and  Credits. — To  illustrate 
the  application  of  these  rules  let  us  assume  that  L.  Gordon  begins 
business  with  a  cash  investment  of  $3,000,  and  during  the  first 
week  proceeds  as  follows: 


12  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Buys  merchandise,  $400,  on  credit,  from  Meyer  A  Co. 

Sells  merchandise  which  cost  190  for  $100,  receiving  cash  in  payment. 

Sells  merchandise  which  cost  $50  for  $40,  receiving  cash  in  payment. 

Incurs  loss  of  $100  on  merchandise,  due  to  fire. 

Sells  to  O.  Rollo,  on  credit,  merchandise  which  cost  $100  for  $150. 

Pays  rent  for  week  $15. 

These  transactions  comprise  the  six  possible  kinds  of  trans- 
actions, as  a  study  of  the  following  entries  recording  them  will 
show: 

Purchases  (wealth  received — Rule  1) $400 .  00 

To  Meyer  &  Co.  (debt  incurred— Rule  5) $400 .  00 

To  record  purchase  on  credit. 

Cash  (wealth  received— Rule  1) $100 .  00 

To  Sales  (wealth  surrendered — Rule  4) $  90 .  00 

Profit  and  Loss  (profits  made — Rule  6) 10 .  00 

To  record  sale,  showing  profit  made. 

Cash  (wealth  received— Rule  1) $  40 .  00 

Profit  and  Loss  (loss  incurred — Rule  3) 10 .  00 

To  Sales  (wealth  surrendered — Rule  4) $  50 .  00 

To  record  sale,  showing  loss  incurred. 

Profit  and  Loss  (loss  incurred— Rule  3) $100 .  00 

To  Purchases  (wealth  surrendered — Rule  4) $100 .  00 

To  record  loss  by  fire  of  goods  purchased. 

O.  Rollo  (wealth  received— Rule  1) $150 .  00 

To  Sales  (wealth  surrendered— Rule  4) $100 .  00 

Profit  and  Loss  (gains  made — Rule  6) 50 .  00 

To  record  sale,  and  profit  made. 

Profit  and  Loss  (expense  incurred — Rule  2) $  15 .  00 

To  Cash  (wealth  surrendered — Rule  4) $  15 .  00 

To  record  rent  payment,  or  expense  incurred. 

These  entries  require  some  elucidation.  It  is  customary  to 
adopt  terms  which  signify  the  uses  to  which  they  are  put.  Thus 
when  merchandise  is  purchased,  "purchases"  is  debited,  and 
when  merchandise  is  sold,  "sales"  is  credited.  When  a  loss  is 
incurred  "loss"  might  be  debited  and  when  a  profit  is  made 
"profit"  might  be  credited,  or,  following  custom,  the  two  terms 
may  be  united  as  "profit  and  loss"  to  which  losses  are  charged 
and  profits  credited,  as  shown  above.  If  desirable  to  specialize 
on  losses  and  profits,  showing  the  different  kinds,  special  terms 
may  be  used  to  indicate  different  kinds  of  losses,  expenses,  and 
profits.  Thus  in  the  last  entry  the  debit  might  have  been  made 
to  "rent  expense,"  or  simply  "rent,"  the  word  "expense"  being 
implied. 

Lfosses  and  Expenses  Distinguished. — Although  the  phrase 
"  profit  and  loss  "  does  not  distinguish  between  losses  and  expenses, 


RECORDING  FINANCIAL  TRANSACTIONS  13 

both  being  comprehended  under  the  single  word  "loss,"  it  is  well 
for  the  beginner  to  make  the  distinction  in  his  own  mind  at 
least.  Expenses  are  incurred  in  order  that  profits  may  be  made. 
For  this  reason  outlays  are  made  for  advertising,  heat,  light,  and 
so  on.  When  losses  occur  they  in  no  way  give  rise  to  profits, 
unless  indirectly,  but  usually  not  at  all.  A  loss  is  sustained  when 
merchandise  is  sold  below  cost.  An  expense  is  incurred  when  a 
building  is  rented.  Losses  remain  uncompensated;  expenses  do 
not.  Losses  are  avoided  as  far  as  possible.  Their  diminution 
is  a  favorable  indication.  Expenses  are  to  be  avoided  only  when 
they  turn  out  to  be  losses,  failing  to  pay  for  themselves  through 
increased  profits. 


CHAPTER  III 

RECORDING  FINANCIAL  TRANSACTIONS— (Con^inwed) 

Subdivision  of  the  Journal. — We  have  found  that  transactions 
are  made  on  either  a  cash  or  a  credit  basis.  Acting  according  to 
this  twofold  classification  it  is  desirable  to  make  a  subdivision  of 
the  Journal  into  two  parts,  one  part  to  be  employed  exclusively 
for  cash  transactions  and  the  other  part  for  all  other  transactions. 
We  can  best  secure  an  understanding  of  the  functions  of  these 
subdivisions  by  first  making  a  threefold  classification  of  journal 
entries  as, 

1.  Those  in  which  cash  does  not  enter. 

2.  Those  in  which  cash  enters  as  a  receipt. 

3.  Those  in  which  cash  enters  as  a  disbursement. 
Classifying  the  journal  entries  given  above  (page  12)  on  this 

threefold  basis,  we  have: 

1.  Those  in  which  cash  does  not  enter: 

Purchases $400.00 

To  Meyer  «fe  Co $400.00 

Profit  and  Loss $100.00 

To  Sales $  100 ,  00 

O.  RoUo $150.00 

To  Sales $100.00 

Profit  and  Loss 50.00 

2.  Those  in  which  cash  enters  as  a  receipt: 

Cash $100.00 

To  Sales $  90.00 

Profit  and  loss 10.00 

Cash $  40.00 

Profit  and  Loss 10.00 

To  Sales $  50.00 

3.  Those  in  which  cash  enters  as  a  disbursement: 

Profit  and  Loss $  15.00 

To  Cash $  15 .  00 

The  Cash  Journal  or  Book. — The  integration  here  shown  is  the 
one  which  has  really  occurred  in  the  evolution  of  accounts. 
However,  instead  of  having  three  Journals,  as  the  above  classifi- 
cation suggests,   the  two  possible   Cash  Journals  are  usually 

14 


RECORDING  FINANCIAL  TRANSACTIONS  15 

united  in  one  book  which  may  be  termed  either  the  Cash  Journal 
or  the  Cash  Book.  We  shall  use  the  former  term  in  this  book. 
When  this  is  done  the  two  pages  of  the  Cash  Journal  facing  each 
other,  right  and  left,  respectively  are  in  reality  the  cash  receipts 
and  cash  payments  Journals,  although  the  plural  title  is  not  used. 


Cash  Journal  (or  Book) 

i 
Month  i  Day  ,   Explanation 

!        1 

F 

Amt.           Month    |  Day 

l(                      1 

Explanations 

F 

Amt. 

Sales 
Sales 

100 
40 

1             !  Expense 

15 

The  entries  are  the  same  as  those  shown  on  page  12,  but  note 
that  each  transaction  occupies  but  one  line  in  the  Cash  Journal, 
whereas  in  the  General  Journal  (the  term  "general"  being  used 
to  distinguish  this  Journal  from  the  Cash  Journal)  two  lines 
were  occupied,  the  upper  for  the  debit  item  and  the  lower  for 
the  credit  item.  This  economizing  of  space  and  work  is  possible 
because  the  entries  on  the  left  page  in  the  Cash  Journal  are 
exclusively  those  representing  cash  receipts  or  debits,  while  the 
entries  on  the  right  hand  page  are  exclusively  those  representing 
cash  payments  or  credits.  Consequently  the  total  debit  and 
the  total  credit  to  cash  can  be  found  at  any  time  by  adding  the 
columns  on  the  left  and  right  pages  of  the  Cash  Journal. 

How  Losses  and  Gains  are  Accounted  for. — Although  the 
entries  in  the  Cash  Journal  represent  the  same  transactions  as 
those  given  on  page  12,  there  exist  certain  discrepancies  be- 
tween them.  The  charges  and  credits  to  Profit  and  Loss  do  not 
appear  in  the  Cash  Journal  while  sales  is  credited  $100  and  $40, 
respectively.  Both  methods  are  correct,  but  it  is  not  usual  to 
show  the  amount  to  be  charged  or  credited  to  Profit  and  Loss 
each  time  entry  is  made  for  a  transaction.  This  procedure  was 
followed  on  page  12  to  illustrate  two  of  the  six  rules  of  debit  and 
credit.  In  practice  it  is  easier  to  let  such  losses  and  gains  go 
unaccounted  for  until  the  close  of  the  accounting  period,  which 
is  usually  a  month  or  a  year.  To  look  up  the  cost  of  goods  sold 
each  time  a  sale  is  consummated  entails  too  much  work.  It  is 
better  to  enter  the  credit  to  Sales  at  the  selling  price.  Then  at 
the  end  of  the  accounting  period,  by  a  process  explained  later  on 
in  this  book,  the  cost  of  all  goods  sold  during  the  accounting 
period  is  ascertained — thus  arriving  at  the  same  result,  namely, 


16  ACCOUNTS  IN  THEORY  AND  PRACTICE 

the  loss  or  gain  made  on  their  sale,  with  much  less  labor.  Had 
we  followed  this  plan  in  making  the  journal  entry  on  page  12, 
in  which  a  loss  of  $10  is  incurred  on  a  sale  of  $40,  it  would  have 
appeared, 

Cash $40.00 

To  Sales  (selling  price) $40.00 

instead  of, 

Cash $40.00 

Profit  and  Loss 10.00 

To  Sales  (cost  price) $50 .  00 

When  we  follow  the  usual  custom  of  entering  a  sale  of  goods  at 
selling  price,  whether  that  be  above  or  below  cost,  our  work 
remains  incomplete  because  the  loss  or  gain,  represented  by 
the  difference  between  cost  and  selling  price,  is  not  shown. 
This  incompleteness  is  a  sacrifice  made  to  save  labor.  The  Cash 
Journal  might  easily  be  arranged  to  indicate  separately  the  loss 
or  gain  on  each  sale,  were  it  practicable  to  find  it. 

I  unction  of  the  Journals. — The  word  "journal"  is  an  adapta- 
tion from  the  French,  journal,  meaning  daily.  As  its  name  implies 
the  Journal  is  a  daily  record.  The  Journals  as  described  in 
this  chapter  are  called  books  of  original  entry.  In  them  records 
of  transactions  are  entered  chronologically,  as  soon  as  possible 
after  the  transactions  are  made.  But  in  addition  to  a  chrono- 
logical record,  which  is  based  primarily  on  time  of  occurrence  of 
transactions,  there  is  needed  another  record  based,  not  on  time, 
but  on  the  character  and  meaning  of  the  transactions.  The 
books  of  original  entry,  chronologically  compiled,  serve  as  a 
trustworthy  source  of  information;  but  as  information  is  arranged 
therein  it  is  unsystematic  and  difficult  to  interpret.  With  but 
one  exception,  cash,  the  items  in  the  General  and  Cash  Journals 
require  analyzing  on  the  basis  of  function;  that  is,  these  various 
items  representing  exchanges  of  wealth,  and  losses,  expense  and 
gains  need  classifying  on  the  basis  of  the  "account"  which  they 
affect. 

"Account"  Defined. — An  "account"  is  a  statement  showing 
the  various  items,  in  dollars  and  cents,  which  affect  the  value  of 
any  thing  or  class  of  things  owned — which  are  termed  assets — 
or  any  sum  owed — which  is  a  liability — or  of  any  expense,  or 
profit,  or  loss,  or  any  class  of  these. 

Function  of  the  Ledger. — To  provide  a  record  in  which  trans- 
actions may  be  grouped  according  to  their  influence  on  accounts, 


RECORDING  FINANCIAL  TRANSACTIONS  17 

is  the  purpose  of  the  Ledger.  In  the  Ledger  are  kept  accounts 
for  such  assets,  liabihties,  expenses,  losses  and  gains  as  the  re- 
quirements of  business  make  desirable.  The  extent  to  which 
accounts  for  these  ought  to  be  subdivided  and  consequently 
the  number  of  the  accounts  is  a  question  to  be  decided  by  the 
requirements  of  individual  cases. 

Functional  Classification  of  Accounts. — After  John  Allen 
has  completed  his  January  transactions  he  possesses  cash,  mer- 
chandise, and  the  obligation  of  O.  Rollo  to  pay  him  $150.  He 
has  as  liabilities,  an  obligation  to  Meyer  &  Co.,  for  $400.  He 
has  also  incurred  expenses  and  losses  and  made  some  gains. 
We  learn  these  facts  from  a  glance  at  the  journal  entries  on  page 
12.  If  we  rearrange  these  transactions  on  the  basis  of 
accounts  affected,  thus  securing  a  functional  classification,  we 
have  : 


Cash 

Purchases . 


Debited 

Credited 

$100.00 

$   15.00 

40.00 

400.00 

100.00 

50.00 

100.00 

90.00 

400.00 

10.00 

10.00 

100.00 

50.00 

15.00 

150.00 

Sales  (at  cost) 

Meyer  &  Co 

Profit  and  Loss 

O.  Rollo 

Totals $815.00        $815.00 

Here  we  have  the  transactions  classified  on  the  basis  of  func- 
tion. Note  that  in  debiting  Profit  and  Loss  no  distinction  is 
made  between  expenses  and  losses.  This  defect  might  be 
obviated  by  setting  up  several  accounts  and  thus  subdividing 
the  Profit  and  Loss  account,  which  is  here  made  sufficiently 
inclusive  to  cover  all  expenses,  losses,  and  gains.  The  sub- 
divisions may.  be  as  follows: 

Debited  Credited] 

General  Expense $  15 .  00 

100.00 


^^^ {  1000 


Gains. 

3 


( 


$10.00 
50.00 


18  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Two  Classes  of  Accounts. — After  this  manner  accounts  permit 
of  as  great  subdivision  and  classification  as  may  be  desirable. 
A  study  of  the  above  classifications  of  accounts  will  make  obvious 
certain  facts.  One  of  these  facts  is  the  fundamental  distinction 
which  exists  between  those  accounts  that  record  assets  and  liabili- 
ties and  those  that  record  expenses,  losses,  and  gains.  The 
asset  and  liability  accounts  represent  actual  possessions  and 
actual  responsibilities.  The  expense,  loss,  and  gain  accounts, 
on  the  contrary,  merely  measure  the  changes  in  values  that  the 
assets  and  liabihties  have  undergone.  Note  that  expenses 
and  losses  aggregate  $125,  and  gains  $60,  making  a  net  debit  of 
$125  —  $60,  or  $65.  The  following  table  shows  that  this  loss  has 
taken  the  form  of  changes  in  values  of  assets  and  liabilities 
as  shown  below : 

Liabilities  increased : 

1.  Meyer  &  Co $400.00 

Assets  decreased: 

None 00.00 

Total  decrease  of  proprietorship $400 .  00 

Liabilities  decreased: 

None $  00 .  00 

Assets  increased: 

1.  Cash 125.00 

2.  Merchandise* 60.00 

3.  O.  RoUo 150.00 

Total  increase  of  proprietorship $335 .  00 

Net  decrease  of  proprietorship $  65.00 

"Real"  and  "Nominal." — Thus  we  see  that  the  loss  or  gain 
made  in  business  may  be  discovered  without  keeping  a  record 
of  the  expenses,  losses,  and  gains.  However,  it  is  necessary 
to  keep  accounts  for  these  if  we  wish  to  know  just  how  the  loss 
or  gain  occurs.  It  is  only  by  referring  to  the  Profit  and  Loss 
items  that  the  names  and  character  of  the  losses,  expenses 
and  gains  which  give  rise  to  the  net  decrease  of  wealth,  amounting 
to  $65,  can  be  learned.  The  adjective  "real "  is  used  to  designate 
those  accounts  which  record  assets  and  liabilities,  and  the  adjec- 
tive "nominal"  to  refer  to  those  accounts  which  record  the  changes 
which  the  real  accounts  undergo  during  an  accounting  period. 
Therefore  real  accounts  record  assets  and  liabilities,  and  nominal 

*  Found  by  deducting  cost  of  goods  sold  and  destroyed  from  purchases. 


RECORDING  FINANCIAL  TRANSACTIONS  19 

accounts  record  expenses,  losses,  and  gains.  In  one  form  of 
bookkeeping,  called  single  entry,  nominal  accounts  are  not  kept, 
and  the  profit  or  loss  for  a  period  must  be  ascertained  by  finding 
the  net  result  of  the  increases  and  decreases  which  have 
occurred  in  the  assets  and  liabilities,  or  real  accounts,  during  the 
period.  Such  a  system  is  incomplete  because  it  gives  the  results 
as  shown  in  the  alteration  in  the  assets  and  liabilities  but  does 
not  show  how  these  changes  occurred.  In  double  entry  book- 
keeping these  changes  are  analyzed  and  recorded  in  the  nominal 
accounts. 

Significance  of  Real  and  Nominal  Accounts. — The  distinction 
between  real  and  nominal  accounts  must  be  thoroughly  grasped. 
Every  item  entered  in  the  Journals  finds  its  way  into  an  account 
of  one  kind  or  the  other,  or  else  into  one  which  contains  both 
nominal  and  real  elements,  which  is  properly  termed  a  mixed 
account.  To  illustrate  the  meaning  of  mixed  accounts,  assume 
that  O.  Rollo,  whose  account  stands  charged  with  $150,  is  able 
to  pay  only  $100,  in  settlement.  The  remaining  $50  is  loss, 
but  it  stands  in  an  account  which  also  records  an  asset  of  $100. 
We  have  both  a  real  or  asset  item  of  $100  and  a  nominal  or  loss 
item  of  $50  in  the  same  account,  so  that  such  an  account  is 
rightly  termed  "mixed."  When  this  condition  arises  it  is  neces- 
sary to  divide  the  account  into  its  real  and  nominal  elements 
in  order  to  obtain  that  classification  of  all  accounts  into  nominal 
and  real  which  is  essential  to  the  work  of  making  an  accurate 
statement  of  losses,  expenses,  and  gains,  and  another  of  assets  and 
liabilities. 

The  Ledger  Form  Illustrated. — We  have  shown  the  trans- 
actions grouped  chronologically  in  the  Journals.  We  have 
rearranged  these  transactions  according  to  function  on  page  17. 
We  have  learned  that  the  book  in  which  the  transactions  are 
classified  according  to  function  is  called  the  Ledger.  We  have 
also  shown  the  transactions  classified  q|i  to  function,  but  in  non- 
technical form,  on  page  17.  Below,  these  same  accounts 
(functional)  are  entered  in  the  Ledger  in  regular  form : 


20 


ACCOUNTS  IN  THEORY  AND  PRACTICE 


Dr. 


Ledger 


Cr. 


Cash 
100.00 
40.00 
Purchases 
400. 00  I 
Sales 


Meyer  &  Co. 
Profit  and  Loss 
10.00 
100.00 
J5.00 
O.  RoUo 
150.001 


15.00 


100.00 
60.00 

100.00 
90.00 

400.00 

10.00 
50.00 


Chronological  or  Functional  Records. — We  have  now  shown 
the  mode  of  recording  transactions  which  has  been  evolved 
in  accordance  with  the  character  and  meaning  of  the  transactions 
themselves.  We  have  seen  that  these  transactions  can  be  re- 
corded by  either  of  two  fundamental  principles,  (a)  time  of 
occurrence,  and  (6)  financial  effect  or  function.  Both  principles 
must  be  applied,  for  it  is  first  ncessary  to  make  a  chronological 
record  from  which,  in  turn,  the  information  can  be  secured  for 
the  compilation  of  a  record  based  on  the  function  of  transactions. 
The  Journals,  general  and  cash,  are  the  chronological  records  and 
the  Ledger  is  the  functional  record. 

Variation  in  Forms  of  Records. — The  specific  form  which  these 
records  must  be  given  depends  upon  convenience  and  utihty. 
Simple  and  widely  accepted  forms  of  Journals  and  Ledger  have 
been  shown.  Some  variations  from  these  will  be  considered 
later. 

"Posting"  Defined. — Since  the  functional  record,  the  Ledger, 
is  compiled  from  information  recorded  in  the  chronological 
records — the  Journals,  it  is  desirable  to  follow  a  definite  pro- 
cedure in  transferring  this  information  from  the  Journals  to  the 
Ledger.  This  procedure  is  called  "posting."  In  posting  it  is 
not  only  necessary  to  make  a  rearrangement  of  the  items  in 
order  to  form  the  functional  record,  but  it  is  necessary  to  make 
such  notations  in  both  the  chronological  and  the  functional 
records,  i.e.,  the  Journal  and  Ledger,  respectively,  that  the 


RECORDING  FINANCIAL  TRANSACTIONS  21 

page  from  which  they  are  derived  in  the  Journals  will  be  shown 
in  the  Ledger  and  also  that  the  page  to  which  they  are  posted  in 
the  Ledger  will  be  shown  in  the  Journals.  This  result  is  secured 
by  providing  folio  (meaning  page)  columns  in  both  Journals  and 
Ledger  for  the  purpose  of  receiving  figures  designating  the  page 
of  the  complementary  record  to  which  or  from  which,  as  the  case 
may  be,  the  postings  are  made. 

The  "Folio"  Column. — The  location  of  the  folio  column, 
again,  is  a  matter  of  convenience.  In  the  Ledger,  however, 
it  should  be  placed  as  near  as  possible  to  the  column  which  re- 
ceives the  item  posted  from  the  Journal.  Likewise  in  the 
Journals  its  proximity  to  the  money  columns  is  desirable.  In  the 
forms  shown  in  the  following  chapter  the  folio  columns  are 
indicated  by  an  "F."  An  examination  of  these  forms  will 
indicate  the  interrelation  established,  and  its  convenience  for 
purpose  of  reference,  between  the  Journals  and  Ledger. 

Note. — At  this  point  work  should  be  started  on  practice 
Chapter  VII  and  pursued  in  connection  with  the  study  of 
Chapters  IV,  V  and  VI. 


CHAPTER  IV 
THE  FUNCTIONAL  CLASSIFICATION  OF  TRANSACTIONS 

Work  of  Interpretation. — Financial  records,  the  construction 
of  which  was  discussed  in  the  preceding  chapter,  are  the  means 
to  an  end.  After  they  are  constructed,  chronologically  and 
functionally,  they  require  interpretation.  If  we  care  to  fix 
arbitrarily  a  point  at  which  bookkeeping  ends  and  accounting 
begins  it  might  well  be  said  to  be  where  recording  ends  and  inter- 
pretation begins.  We  use  the  word  recording  in  the  narrow  sense 
of  routine  operations.  It  does  not  include  the  work  of  contriving 
the  records,  which  precedes  their  use.  Thus  accounting  precedes 
and  follows  bookkeeping.  Acting  synthetically  or  constructively, 
it  plans  records  best  adapted  to  the  conditions.  Then  book- 
keeping fills  out  the  record.  Finally,  accounting,  operating 
analytically,  interprets  the  record,  making  it  useful  in  proportion 
to  the  accuracy,  skill  and  judgment  employed  throughout  the 
process. 

Value  of  Interpretation. — The  value  of  an  interpretation  of 
financial  records  is  dependent  upon  two  factors,  (a)  the 
thoroughness  and  accuracy  with  which  the  original  or  chrono- 
logical records  are  kept,  and  (6)  the  judgment  and  care  employed 
in  arranging  the  transactions  according  to  function  when  they 
are  posted  to  the  Ledger.  An  outline  of  transactions  based  on 
their  functions  was  presented  in  Chapter  III.  It  was  there  shown 
that  a  debit  means  one  or  more  of  three  things,  (1)  wealth  received, 
(2)  expense  incurred,  and  (3)  loss  incurred.  It  was  also  shown 
that  a  credit  means  one  or  more  of  three  things,  (1)  debt  in- 
curred, (2)  wealth  surrendered,  and  (3)  profit  made.  We  have 
found  that  debits  and  credits  may  result  in  any  of  four  ultimate 
consequences: 

1.  Liabilities  increased. 

2.  LiabiUties  decreased. 

3.  Assets  increased. 

4.  Assets  decreased. 

22 


FUNCTIONAL  CLASSIFICATION  OF  TRANSACTIONS       23 

Significance  of  Losses,  Expenses  and  Gains. — It  follows  that 
the  significance  of  "expenses  incurred,"  of  "losses  incurred," 
and  of  "profits  made"  lies  ultimately  in  the  increase  or  decrease 
of  assets  and  liabilities.  Expenses,  losses,  and  profits  merely 
measure  the  amount  of  the  change  in  the  assets  and  liabilities 
and  indicate  the  manner  of  its  occurrence.  They  may  be  com- 
pared to  the  gauge  on  a  tank,  which  indicates  the  changing  level 
of  the  water.  But  they  do  more  than  merely  record  changes  in 
assets  and  liabilities.  They  also  show  the  character  and  amount 
of  both  increases  and  decreases  in  assets  and  liabilities. 

Two  Classes  of  Ledger  Accounts. — The  foregoing  suggests 
the  principle  which  governs  the  functional  classification  of  ac- 
counts, i.e.,  that  there  must  appear  in  the  Ledger  two  distinct 
kinds  of  accounts:  first,  accounts  whose  titles  are  the  names  of 
the  sundry  assets  and  liabilities,  which  are  collectively  known  as 
"real"  accounts;  and,  secondly,  accounts  whose  titles  are  the 
names  of  the  sundry  expenses,  losses,  and  profits,  which  are 
collectively  known  as  "nominal"  accounts.  Since  losses,  ex- 
penses and  profits  result  from  transactions,  there  are  none  until 
transactions  have  occurred.  Hence  there  appear  only  real 
accounts  in  the  Ledger  until  after  transactions  occur  which 
involve  expenses,  losses,  and  profits. 

Capital  Defined. — So  one  about  to  engage  in  business  opens 
ledger  accounts  for  his  sundry  assets,  and  liabilities,  if  there  are 
any  of  the  latter.  If  there  are  liabilities  the  proprietor's  interest 
in  the  assets  is  diminished  to  that  extent.  If,  for  example,  the 
assets  are  worth  $10,000  and  liabilities  amount  to  $5,000,  the 
proprietor's  interest  in  the  assets  is  one-half  of  their  value.  We 
then  say  that  his  net  worth,  or  capital,  is  $5,000.  But  if  one 
begins  business  with  $10,000  in  assets  and  no  liabilities,  his 
interest  is  the  total  value  of  the  assets — which  figure  also  expresses 
his  net  worth  or  capital.  Capital  or  net  worth  is  the  excess  of 
the  value  of  the  assets  over  the  liabilities.  This  may  be  ex- 
pressed in  the  form  of  an  equation,  thus : 

Assets  —  Liabilities  =  Capital 
or  Assets  =  Capital-j-Liabilities 
or  Liabilities  =  Assets  —  Capital 
or  Capital  =  Assets  —  Liabilities 

If  assets  equal  $10,000  and  liabilities  equal  $5,000,  the  equation 
becomes: 


24  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Assets,  $10,000— Liabilities,  $5,000  =  Capital,  $5,000  or  any 
other  of  the  arrangements  suggested  above  may  be  followed.  If 
assets  are  $10,000  and  there  are  no  liabilities,  then, 

Assets,  $10,000  =  Capital,  $10,000 

Statement  of  Assets,  Liabilities  and  Capital. — Before  opening 
a  set  of  books  it  is  necessary  to  make  a  statement  showing  assets, 
liabilities,  and  capital.  The  simplest  condition  is  that  in  which 
cash  is  the  only  asset  and  there  are  no  liabihties.  Thus  if  Grant 
Atkins  invests  $8,000  cash,  and  has  no  liabilities,  his  statement 
appears  as  follows : 

Statement  of  Assets,  Liabilities,  and  Capital,  Grant  Atkins,  as  at  July  2, 1917 

Assets                                       Liabilities  and  Capital 
Cash $8,000     Capital $8,000 


$8,000  $8,000 

But  if,  in  addition  to  cash,  $8,000,  Atkins  possesses  merchandise, 
$5,000,  store  and  lot,  $9,000,  furniture  and  fixtures,  $500,  the 
statement  reads: 

Statement  of  Assets,  Liabilities,  and  Capital,  Grant  Atkins,  as  at  July  2, 1917 

Assets  Liabilities 

Cash $  8,000    None $00,000 

Inventory 5,000 

Store  and  Lot 9,000  Capital 

Furniture  &  Fixtures 500     Grant  Atkins 22,500 

$22,500  $22,500 

Opening  Journal  Entry. — Note  that  this  is  a  functional  classi- 
fication of  transactions,  not  a  chronological  one;  also  that  all  of 
these  accounts  are  real  accounts.  No  nominal  accounts  appear. 
This  is  so  because  no  losses  or  expenses  have  been  incurred  and 
no  profits  made.  These  are  the  accounts  which  ought  to  appear 
in  the  Ledger  before  any  transactions  are  made.  They  might  be 
entered  directly  in  the  Ledger.  However,  it  is  customary  to 
enter  them  first  in  the  Journal  by  means  of  an  "opening  entry," 
as  follows: 


FUNCTIONAL  CLASSIFICATION  OF  TRANSACTIONS      25 


Journal,  Grant  Atkins 


July  2,  1917 

Grant  Atkins  this  day  begins  business 
as  a  retail  grocer  with  assets,  liabilities, 
and  capital,  as  follows: 

Cash , 

Inventory : 

Store  and  Lot 

Furniture  and  Fixtures 

To  Grant  Atkins,  Capital 


8,000.  oq 

5,000.00 

9,000,00 

500.00 


22,500  00 


Arrangement  of  Accounts  in  the  Ledger. — From  the  Journal 
these  items  are  posted  to  the  Ledger,  where  the  arrangement  must 
be  made  as  convenient  as  possible.  In  actual  practice  it  is  best 
to  enter  but  one  account  on  a  ledger  page,  placing  it  at  the  top, 
and  thus  leaving  the  whole  page  for  additional  entries  to  the 
account  as  time  passes.  For  illustrative  purposes,  however, 
two  or  more  accounts  may  be  entered  on  the  same  page.  The 
arrangement  of  the  asset  and  liability  accounts  according  to 
some  plan  is  customary.  This,  however,  is  a  matter  of  detail. 
Usually  the  proprietor's  capital  account  occupies  the  first  page. 
This  may  be  followed  by  the  assets  and  liabilities  in  the  order 
in  which  they  are  shown  in  the  opening  journal  entry.  Possibly 
a  different  arrangement  may  be  preferable.  When  business  gets 
under  way  various  personal  accounts,  both  receivable  and  pay- 
able, will  be  opened;  also  nominal  accounts,  to  record  expenses, 
losses,  and  profits.  The  Ledger  must  be  sufficiently  large  to 
contain  these  accounts  and  make  possible  a  reasonable  amount 
of  expansion  in  the  number  of  the  various  kinds  of  accounts, 
especially  of  the  personal  accounts  receivable  and  accounts 
payable,  which  increase  rapidly  in  number  with  the  growth  of 
business. 

The  Ledger  Illustrated. — When  the  items  in  the  opening 
entry,  shown  above,  are  posted  to  the  Ledger  of  Grant  Atkins, 
one  account  to  a  page,  the  ledger  accounts,  with  cross  references 
placed  in  the  folio  columns,  appear  as  follows:^ 

*  The  word  Sundries,  which  appears  in  the  explanation  column  of  the 
capital  account  of  Grant  Atkins,  is  used  because  sundry  items  were  charged 
in  the  opening  journal  entry. 


26 


ACCOUNTS  IN  THEORY  AND  PRACTICE 


Ledger,  Grant  Atkins 

Grant  Atkins,  Capital 


page  1 


1917 


Capi- 
tal 


July 
Cash 


2  Sundries 


22,500,00 
page  2 


1917 

July 


Capital, 
Grant  Atkins 


8,000  00 


Merchandise 


page  3 


1917 

July 


Capital, 
Grant  Atkins 


F 
Jll  5,000 


00 


Store  and  Lot 


page  4 


1917 

July 


Capital, 
Grant  Atkins 


9,ooo:oo 


Furniture  and  Fixtures 


page  5 


1917 
July 


2  Capital, 

Grant  Atkins 


Jl 

500 

00 

F 

"Cash"  in  the  Opening  Entry. — Although  all  cash  transactions 
are  ordinarily  brought  into  the  cash  journal,  it  is  best  to  bring 
the  cash  invested  into  the  opening  journal  entry  with  the  other 
assets.  It  may  also  be  entered  in  the  Cash  Journal,  if  desirable. 
Where  this  is  done  it  is  necessary  to  check  ( l^  )  this  item  either 
in  the  General  Journal  or  the  Cash  Journal  to  avoid  posting  it 
twice.  If  it  is  entered  in  the  Cash  Journal  but  posted  from  the 
General  Journal,  the  left  side  of  the  Cash  Journal  should  appear 
thus,  after  the  item  is  checked  off: 

Cash  Journal,  Grant  Atkins 


1917 

July 


Capital,  Grant  Atkins. 


8,000 


00 


FUNCTIONAL  CLASSIFICATION  OF  TRANSACTIONS      27 

The  ( 1/ )  in  the  folio  column  shows  that  this  item  is  not  to  be 
posted.  If,  on  the  other  hand,  it  is  thought  best  to  post  the 
item  from  the  Cash  Journal  it  may  be  checked  off  in  the  General 
Journal  also. 

Entries  for  Routine  Transactions. — All  entries  in  the  Journals 
having  been  posted  or  checked  off,  the  books  now  await  the 
entries  which  arise  from  the  ordinary  routine  of  business.  These 
will  record  chiefly  purchases,  sales,  losses,  profits  and  expenses. 
It  is  therefore  necessary  to  reserve  one  section  of  the  Ledger  for 
the  reception  of  creditor's  accounts,  i.e.,  the  accounts  of  those 
from  whom  we  purchase  on  credit ;  another  section  of  the  Ledger 
for  the  reception  of  debtor's  accounts,  i.e.,  the  accounts  of  those 
to  whom  we  sell  on  credit;  and  another  section  for  the  reception 
of  nominal  accounts,  i.e.,  those  which  record  losses,  expenses,  and 
profits. 

Accounts  Payable  and  Accounts  Receivable. — The  accounts 
with  creditors  are  collectively  called  "accounts  payable."  The 
accounts  with  debtors  are  collectively  called  "accounts  receiv- 
able." The  number  of  these  two  classes  of  accounts  lies  largely 
beyond  control,  it  being  dependent  upon  the  character  and 
growth  of  the  business.  The  number  of  the  nominal  accounts  is 
ordinarily  a  voluntary  matter.  It  would  even  be  possible  to 
have  one  general  nominal  account  called  "profit  and  loss,"  or 
more  logically,  "profit,  loss,  and  expense,"  into  which  all  nominal 
debits  and  credits  would  be  posted  from  the  Journals.  The  sole 
recommendation  of  this  plan  is  its  simplicity.  By  lumping 
together  all  of  the  nominal  items  the  account  becomes  hetero- 
geneous and  unintelligible;  thus  the  Ledger's  purpose,  which 
is  to  furnish  a  functional  classification,  is  to  that  extent 
negatived. 

Analysis  of  Losses,  Expenses  and  Profits. — We  must  know  not 
merely  the  net  effect  of  losses,  expenses,  and  pr<ifits;  we  must 
also  learn  definitely  the  causes  or  conditions  leading  to  it.  If  a 
proprietor  sustains  a  net  loss  of  $1,000  in  a  month,  he  seeks  to 
discover  the  causes  of  that  loss.  To  do  this  he  analyzes  his 
expenses,  losses,  and  profits.  Thus  he  is  enabled  to  find  where 
increases  and  decreases  have  occurred  during  the  preceding 
month  or  months  and  to  take  steps  necessary  to  remedy  the  evil. 
With  the  above  considerations  in  mind,  study  the  following 
subdivision  of  the  profit  and  loss  account: 


28  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Expenses  and  Losses: 
Rent  Expense 
Wages  Expense 
Stable  Expense 
Heat  and  Light  Expense 
Miscellaneous  Expenses  and  Losses 

Profits: 

Merchandise  (on  Sales) 
Miscellaneous 

Subdivision  of  Accounts. — The  subdivision  of  accounts  is  an 
endless  process.  It  is  limited,  however,  by  practical  considera- 
tions. A  small  concern  naturally  demands  a  less  minute  sub- 
division of  accounts  than  a  large  one  having  a  great  variety  of 
expenses  and  many  sources  of  profit.  Ledger  accounts  may  be 
opened  for  as  many  separate  kinds  of  nominal  items  as  it  is 
desirable  to  keep  separately  recorded.  Separate  accounts  should 
be  opened  for  the  more  important  nominal  factors,  the  smaller 
and  less  significant  ones  being  grouped  together  under  "miscella- 
neous" or  "general  expense."  Accounts  must  supply  in- 
formation required  by  the  manager;  the  classification  must  be 
adapted  to  that  end. 


CHAPtER   V 

FUNCTIONAL  CLASSII- ICATION  OF  TRANSACTIONS 
ILLUSTRATED 

Accounting  Procedure.^ — Let  us  assume  that  during  the 
month  of  July,  1917,  Grant  Atkins  carries  on  business  as  follows: 

July  2.  Buys  merchandise  on  account  from  Baxter  and  Company, 
$400.  Pays  rent  for  month,  $35.  Sells  merchandise  on  account  to  Mr. 
Buckley,  $15,  and  to  Aaron  Cole,  $17.  Buys  stable  supplies, sufficient  to 
last  2  months,  $40,  cash. 

(3)  Buys  merchandise  on  account  from  Baker  Wholesale  Company, 
$725.00. 

(6)  Pays  for  stationery  and  printing,  $3.10,  cash.  Sells  on  account  to 
L.  Laurens,  $23.00. 

(7)  Cash  sales  for  week,  $348.47.  Sells  on  account  to  Mr.  Buckley, 
$12.20,  and  to  S.  Sherman,  $17.00. 

(10)  Pays  Baxter  &  Co.  Bill  of  July  2,  $400.  Buys  on  account  from  the 
Milton  Company,  merchandise,  $370. 

(11)  Mr.  Buckley  pays  account  in  full,  $27.30. 

(12)  Sells  on  account  to  James  Whittlesey,  $27.20. 

(14)  Pays  wages  for  2  weeks:  bookkeeper,  $30;  clerk,  $25;  delivery  boy, 
$15. 

(16)  Pays  for  advertising,  $10.     Cash  sales  for  week,  $360.92. 

(17)  S.  Sherman  pays  $10  on  account. 

(18)  Buys  from  Armstrong  Supply  Co.,  merchandise  $55.00,  on  account. 
(21)  Cash  sales  for  week,  $335.20. 

(23)  Miscellaneous  expense,  cash,  $3.27.  Sells  on  account  to  Oscar 
Morgan,  merchandise,  $14.00. 

(24)  Pays  Baker  Wholesale  Co.  bill  of  $725.30. 
(27)  Sells  on  account  to  James  Whittlesey,  $14.20. 

(31)  Pays  wages:  bookkeeper,  $30;  clerk,  $25;  delivery  boy,  $15.  Pays 
light  bill  for  month,  $5.60.  Miscellaneous  expense,  cash,  $6.20.  Cash 
sales  for  week,  $397.20.  One-half  of  stable  supplies  are  consumed  during 
the  month. 

The  cash  sales  are  given  weekly,  the  daily  cash  sales  having 
been  kept  on  subordinate  records  to  avoid  making  daily  entries 
for  this  item  in  the  Cash  Journal.  Below  are  shown  the  Journals 
and  Ledger  of  Grant  Atkins  as  they  appear  at  the  close  of  business 
July  31,  1917,  after  all  transactions  are  entered  and  posted: 

29 


30 


ACCOUNTS  IN  THEORY  AND  PRACTICE 
General  Journal,  Grant  Atkins 


July  2,  1917 
Grant  Atkins  this  day  begins  business  as  a 
retail  grocer,  with  assets,  liabilities  and 
capital,  as  follows: 

Cash 

Inventory 

Store  and  Lot 

Furniture  and  Fixtures 

Grant  Atkins,  Capital 

Purchases 

To  Baxter  &  Company 

Purchase  on  credit. 

Mr.  Buckley 

To  Sales 

Aaron  Cole 

To  Sales 

July  3 

Purchases 

To  Baker  Wholesale  Co 

July  6 

L.  Laurens 

To  Sales 

July  7 

M.  Buckley 

To  Sales 

S.  Sherman 

To  Sales 

July  10 

Purchases 

To  Milton  Company 

July  12 

James  Whittlesey 

To  Sales 

July  18 

Purchases 

To  Armstrong  Supply  Co 

July  23 

Oscar  Morgan 

To  Sales 

July  27 

James  Whittlesey 

To  Sales . 


8,000 

5,000 

9,000 

500 

400 


15 
17 

725 

23 

12 

17 

370 
27 
55 
14 
14 


00 
00 

ool 
oo| 

00 


00 
00 

30 

00 

20 
00 

00 

00 

00 

00 

20 


22,500  00 
400  00 

15,00 
17  00 

72530 


23 


00 


1220 
17;00 


370 


27 


55 


00 


00 


00 


1400 


14 


20 


FUNCTIONAL  CLASSIFICATION  OF  TRANSACTIONS       31 


Cash  Journal,  Grant  Atkins 


Cash  Dr. 


Cash  Cr. 


1917 
July 


Aug. 


Sundries . , 

Sales  (cash) 

M.  Buckley  (in  full) 

Sales  (cash) 

S.  Sherman  (on  ac- 
count)   

Sales  (cash) 

Sales  (cash) 


8,000  00 

348147 

27,20 

360  92 

1000 
335120 
397  20 


1917 
July 


Cash  Dr 2  9,478  99 


Balance. 


8,110 


52 


16 


31 


Rent  expense,  for  mo. 

Stable  supplies 

Miscellaneous  expense 

(Sta.  &  Print 

Baxter     &    Co.    bill, 

July  2 

Wages:  Bookpr..   30 

Clerk....   25 

Delivery  boy  15 

Miscellaneous  expense 

(advertising) 

Misc.  expense 

Baker  Wholesale  Co. 

bill  July  3 

Wages:  Bookpr. .   30 

Clerk....    25 

Delivery  boy  15 

Fuel  &  light  (light  for 

mo.) 

Misc.  exp 

Cash  Cr 

Balance 


35100 
40  00 


3 
400 


70 


00 


10,00 


3 
725 


70 


00 


5:60 
6  20 


2  1,368  47 
8,110  52 

I  9,478  99 


32 


ACCOUNTS  IN  THEORY  AND  PRACTICE 


Ledger,  Grant  Atkins 
Real  Accounts  Division  of  Ledger 


page  1 


Capit 

al 

— Gr  an' 

t  Atkins 

1917 

July 

1 

By  Sundries 

Jl 

22,600 
page 

00 
2 

C 

ash 

1917 

1917 

July 

2 
31 

To  Sundries 

8,100.52 

C.J.I 

9.478 

99 

July 

31 

By  Sundries 

C.J.I 

1.368 
page 

47 
3 

Inv 

en 

tory 

1917 

July 

2 

To  Sundries 

Jl 

5,000 

00 

page 

3 

Pure 

ha 

ses 

1917 

July 

2 
3 

10 

To  Baxter  &  Co. . 
To  Baker  Whole- 
sale Co 

Jl 

Jl 
Jl 

400 

725 
370 

00 

30 
00 

To  Milton  Co 

18 

To  Armstrong  Sup- 
ply Co,     1.550.30 

Jl 

55 

00 

page 

3 

Sa 

les 
1917 

July 

2 
2 

7 

12 
16 
21 
23 
27 
31 

By  M.  Buckley.. . 
By  Aarou  Cole. . . 
By  L.  Laurens. . . . 

By  Cash 

By  M.  Buckley... 
By  S.  S.  Sherman. 
By  J.  Whittlesey.. 

By  Cash 

By  Cash 

By  O.  Morgan 

By  J.  Whittlesey.. 
By  Cash 

Jl 

Jl 

Jl 

C.J.I 

Jl 

Jl 

Jl 

C.J.I 

C.J.I 

J2 

J2 

J2 

15 
17 
23 

348 
12 
17 
27 

360 

335 
14 
14 

397 

00 
00 
00 
47 
20 
00 
00 
92 
20 
00 
20 
20 

1,581.19 

FUNCTIONAL  CLASSIFICATION  OF  TRANSACTIONS       33 


Ledger,  Grant  Atkins 
Nominal  Accottnts  Division  of  Ledger 


page  100 


1917 

July    2 


To  Cash . 


Rent  Expense 
C.J.I   35.00 


page  101 


1917 

July  6 
16 
23 
31 


To  Cash . . 
To  Cash.. 
To  Cash.. 
To  Cash . . 

22.57 


Miscellaneous  Expense 
C.J.I     3.10 
C.J.I   10.00 
C.J.I     3.27 
C.J.I     6.20 


page  102 


1917  Wages  Expense 

July  14    To  Cash....  C.J.I   70.00 

31    To  Cash ....  C.J.I   70.00 

140.00 


page  103 


1917  Fuel  and  Light  Expense 

July  31    To  Cash ....    C.J.I     5 .  60 

Ledger,  Grant  Atkins 
AccoiTNTs  Payable  Division  of  Ledger 


page  40 


Baxter  &  Co. 

1917  1917 

July  10  To  Cash...    C.J.I   400.00     July    2  By   Purchases.    J. 


1   400.00 
page  41 


Baker  Wholesale  Co. 

1917  1917 

July  24  To  Cash C.J.I   725.30     July    3  By   Purchases.    J.l   725.30 

page  42 
Milton  Co. 

1917 
July  10  By  Purchases.    J.l  370.00 

page  43 
Armstrong  Supply  Co. 
1917 
July  18  By   Purchases.    J.l     65.00 

Ledger,  Grant  Atkins 

Accounts  Receivable  Division  of  Ledger 

page  80 


1917 

July  2 
7 
3 


M.  Buckley 

1917 

ToSalea J.l     15.00    July  11  By  Cash. .. ,   C.J.I     27.20 

To  Sales J.l      12.20 


34  ACCOUNTS  IN  THEORY  AND  PRACTICE 

page  81 

Aaron  Cole 

1917 

July    2  To  Sales J.l      17.00 

page  82 
L.  Laurens 
1917 

July  6    To  Sales J.l     23.00 

page  83 
S.  Sherman 

1917  1917 

July    7  To  Sales J.l     17.00     July  17  By  Cash. .. .    C.J.I     10.00 

7.00 

page  84 
James  Whittlesey 
1917 

July  12  To  Sales J.l     27.00 

27  To  Sales J.2     14.20 

41.20 

page  85 

Oscar  Morgan 

1917 

July  23  To  Sales J.2     14.00 


CHAPTER  VI 
INTERPRETATION  OF  LEDGER  ACCOUNTS 

Grouping  Ledger  Accounts. — The  ledger  accounts  shown  in 
the  preceding  chapter  require  some  study.  They  represent 
the  functional  classification  of  the  transactions  which  were 
recorded  chronologically  in  the  Journals.  They  have  been 
grouped  into  classes  in  the  Ledger,  on  the  basis  of  similarity — 
accounts  receivable  in  one  section  of  the  Ledger,  accounts  payable 
in  another,  and  so  on.  Strictly  speaking,  the  nominal  accounts 
cannot  be  entirely  isolated,  because  some  of  the  accounts  in 
other  sections  are  sometimes  mixed,  and  so  contain  nominal 
elements. 

Interpretation  of  Accounts — The  Trial  Balance. — Recording 
ends  when  the  ledger  accounts  are  set  up  and  all  transactions  are 
posted  to  them.  At  this  point  the  work  of  interpretation  begins. 
First,  however,  it  is  necessary  to  "take  a  trial  balance"  of  the 
Ledger.  The  purpose  of  the  trial  balance  is  to  prove  the  cor- 
rectness of  the  recording,  within  certain  limits,  and  to  supply  a 
statement,  which  can  be  made  the  basis  of  the  work  of  interpreta- 
tion. A  trial  balance  consists  of  a  schedule  of  the  balances 
of  the  various  ledger  accounts,  Usted  in  two  columns,  debit  and 
credit,  accordingly  as  the  balances  are  debit  or  credit  balances. 
An  account  has  a  debit  balance  when  the  amount  charged  to  it 
exceeds  the  amount  credited  to  it.  It  has  a  credit  balance  when 
the  amount  credited  to  it  exceeds  the  amount  charged  to  it. 
When  it  is  desirable  to  indicate  what  the  balance  of  an  account 
is  it  may  be  written  in  small  figures  on  the  proper  side  of  the 
account,  as  shown  in  the  ledger  accounts  in  the  preceding 
chapter.  A  trial  balance  made  up  of  these  balances  is  given 
below. 

Nature  of  the  Trial  Balance. — The  balances  are  grouped  here 
to  correspond  with  the  classification  of  the  ledger  accounts, 
although  this  is  not  necessary,  and  in  practice  such  a  grouping 
is  not  usually  followed.  Perhaps  the  most  striking  feature  of  the 
trial  balance  is  the  equality  of  the  two  columns.  This  fact 
is  an  outgrowth  of  the  nature  of  the  entries  made  in  the  Journals, 

36 


1< 


36  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Trial  Balance,  Grant  Atkins,  as  at  July  31, 1917 

f  Capital— Grant  Atkins $22,500. 00 

I  Cash , 8,110.52 

Store  and  Lot 9.000.00 

Furniture  and  Fixtures 500.00 

Stable  Supplies 40.00 

Rent  Expense 35. 00 

Purchases 1,550. 30 

Sales ; 1,581 .  19 

Miscellaneous  Expense 22 .  57 

Inventory,  July  2,  1917 5,000.00 

Wages  Expense 140 .  00 

Fuel  and  Light  Expense 5 .  60 

r  Milton  Co 370. 00 

I  Armstrong  Supply  Co 55 .  00 

Aaron  Cole 17.00 

L.  Laurens 23 .  00 

S.  Sherman 7 .  00 

James  Whittlesey 41 .20 

Oscar  Morgan 14 .  00 


4 


$24,506.19   $24,506. 19 

namely,  the  equality  of  debits  and  credits.  This  equality  per- 
sists in  the  Ledger,  for  all  debits  in  the  Journals  become  debits 
in  the  Ledger,  and  all  credits  in  the  Journals  become  credits 
in  the  Ledger.  Although  we  take  only  the  balances  of  the  ledger 
accounts  into  the  trial  balance,  these  are  sufficient  because  the 
total  of  the  debit  balances  will  equal  the  total  of  the  credit 
balances  if  the  posting  is  done  correctly  and  no  omissions  are 
made.  The  balances  of  the  two  accounts  are  the  uncancelled 
portions.  Since  the  cancelled  parts  of  the  accounts  are  equal, 
debit  for  credit,  it  follows  that  the  sum  of  the  debit  balances 
must  equal  the  sum  of  the  credit  balances. 

Consequently  it  is  sufficient  to  include  in  the  trial  balance 
merely  the  balances  of  the  ledger  accounts.  However,  a  trial 
balance  may  be  made  up  of  the  total  charges  and  credits  in  the 
ledger — an  unnecessary  increase  of  work  over  the  usual  method. 
It  would  require  the  inclusion  of  all  accounts,  even  though  some 
stand  debited  and  credited  with  equal  amounts.  When  bal- 
ances only  are  taken  into  the  trial  balance  these  latter  are  con- 
veniently ignored. 

An  examination  of  the  trial  balance  affords  interesting  results. 
The  first  of  the  four  divisions  consists  of  the  balances  of  miscel- 


INTERPRETATION  OF  LEDGER  ACCOUNTS  37 

laneous  real  and  mixed  accounts,  but  excludes  accounts  receiv- 
able and  accounts  payable.  The  first  and  second  divisions  are 
balances  of  impersonal  accounts.  The  third  and  fourth  divisions 
are  balances  of  personal  accounts.  The  first  division  is  com- 
posed of  the  real  accounts.  The  balances  in  divisions  three  and 
four  are  real  with  the  possible  exception  of  nominal  elements  in 
section  three,  resulting  from  uncollectible  accounts. 

Two  Chief  Purposes  of  the  Trial  Balance. — The  trial  balance 
checks  up  work  done  and  serves  as  a  basis  for  an  interpretation 
of  the  Ledger  from  which  it  is  taken.  It  contains  most  of  the 
information  needed  for  such  an  interpretation,  which  is  the  next 
step  in  accounting  procedure. 

Mixed  Accounts. — ^As  already  shown,  nominal  accounts  record 
expenses,  losses,  and  profits.  From  an  examination  of  section  ,2 
of  the  trial  balance  one  might  therefore  conclude  that  expenses 
and  losses  are  far  in  excess  of  gains  since  the  nominal  debit  bal- 
ances make  a  total  of  $6,753.47  while  the  single  nominal  credit 
balance,  "sales,"  is  but  $1,581.19.  The  secret  of  the  matter  lies 
in  the  balances  of  the  "Purchases"  and  "Inventory  July  2" 
accounts.  These  are  in  reality  mixed  accounts  because  not  all 
of  the  merchandise  on  hand  at  the  beginning  of  the  month  and 
purchased  during  the  month  has  been  sold.  Assume  that  an 
actual  tabulation  shows  that  merchandise  on  hand  amounts  to 
$5,400,  cost  price.  This  means  that  the  actual  total  of  the 
nominal  debit  balances  is  $6,753,47 — $5,400,  or  $1,353.47,  for 
it  is  only  by  extracting  the  real  item  of  $5,400  from  the  mixed 
debit  balances  that  we  secure  the  purely  nominal  elements.  The 
inventory  for  July  2  is  the  old  or  nominal  inventory.  The 
inventory,  $5,400,  for  July  31,  is  the  new  or  real  inventory. 
The  operation  required  may  be  simply  illustrated  as  follows. 
Assume  that  we  have  2  bushels  of  wheat  which  cost  $1  per  bushel. 
We  buy  2  additional  bushels  at  the  same  price.  We  sell  2 
bushels  at  $1.50  per  bushel.  We  then  have  remaining,  as  an 
inventory  should  show,  2  bushels  of  wheat,  cost,  $2.  Placing 
these  transactions  and  facts  in  technical  form  we  have: 

Inventory  (old) 
ToSundries s 2.00 

Purchases 
To  Cash 2.00 

Sales 

By  Cash 3.00 


57159 


38  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Here  we  have  debits  amounting  to  $4.00  and  credits  amounting 
to  $3.00.  It  is  only  by  remembering  that  only  one-half  of  our 
wheat  is  sold,  and  that  therefore  one-half  of  the  debits,  or  $2,  is 
real,  that  we  can  account  for  the  profit  made,  $1.00,  which  is 
represented  by  the  excess  of  the  nominal  credit  items,  $3,  over 
the  nominal  debit  items,  $2.  The  result  can  best  be  shown  by 
closing  the  old  inventory,  purchases,  and  sales  accounts  into  a 
single  profit  and  loss  account,  which  should  also  be  credited  with 
the  amount  of  the  new  inventory  and  a  "new"  inventory  ac- 
count charged.  This  is  best  done  by  means  of  journal  entries, 
thus:i 

Profit  and  Loss $2.00 

To  Inventory  (old) $2 .  00 

Profit  and  Loss $2.00 

To  Purchases $2.00 

Sales $3.00 

To  Profit  and  Loss : $3.00 

Inventory  (new) $2 .  00 

To  Profit  and  Loss $2 .  00 

When  these  entries  are  posted  to  the  Ledger,  the  old  inventory 
purchases,  and  sales  accounts  are  closed  and  new  accounts 
opened  as  follows : 

Profit  and  Loss 

To  Inventory  (old) 2.00     By  Sales 3.00 

To  Purchases 2 .  00     By  Inventory  (new) 2 .  00 

Inventory  (new) 
To  Profit  and  Loss 2.00 

The  profit  and  loss  account  now  contains  a  purely  nominal 
balance,  which  is  a  credit  of  $1,  representing  profit  made.  The 
new  inventory  account  is  real,  showing  the  worth  of  the  wheat 
still  on  hand.  Had  there  been  any  expenses  incurred  in  con- 
nection with  the  purchase  and  sale  of  the  wheat  these  would 
appear  in  suitable  nominal  accounts  and  should  likewise  be 
closed  into  the  profit  and  loss  account  by  suitable  journal  entries, 
thus  reducing  the  credit  balance  to  the  actual  profit  made,  or 
possibly  showing  a  net  debit  balance,  therefore  a  loss. 

The  entries  required  to  close  all  the  nominal  accounts  shown 

1  Sometimes  the  inventory,  purchases  and  sales  accounts  are  carried  to 
"merchandise"  and  the  balance  of  merchandise  to  profit  and  loss.  The 
net  result  is  the  same  by  either  method. 


INTERPRETATION  OF  LEDGER  ACCOUNTS 


39 


in  the  trial  balance  of  Grant  Atkins  into  profit  and  loss  are  as 
follows : 


Profit  and  Loss $1,550.30 

To  Purchases 

Sales $1,581 .  19 

To  Profit  and  Loss 

Profit  and  Loss $5,000.00 

To  Inventory  (old) 

Inventory  (new) $5,400 .  00 

To  Profit  and  Loss 

Profit  and  Loss $    223. 17 

To  Stable  Supplies 

Rent  Expense 

Miscellaneous  Expense 

Wages 

Fuel  and  Light 


$1,550.30 

$1,581.19 

$5,000.00 

$5,400.00 

$      20.00 

35.00 

22.57 

140.00 

5.60 


Closing  the  Nominal  Accounts. — When  these  entries  are  posted 
to  the  proper  ledger  accounts  all  the  nominal  accounts  balance 
and  may  be  closed  by  adding  up  to  the  two  sides  and  underlining 
the  totals,  or  if  there  is  but  one  item  on  each  side,  by  merely 
underlining  each  item,  debit  and  credit,  respectively.  Thus  the 
purchases  account  will  appear  as  follows: 


Purchases 


F 


1917 

July 


To    Baxter    & 
Co Jl 

To  Baker  Whsl  I 
Co Jl 

To  Milton  Co.  'jl 

To  Armstrong  I 
Supply  Co....! Jl 


400 

725 
370 

65 


1,550  30 


1917 

July 


31 


By  Profit  and 
Loss 


J? 


1,550 


1,550 


30 


30 


and  the  rent  expense  account  as  follows: 

Rent  Expense 


1617  I    i  \ rn — pMT — : r— i — i — p 

July  I  2|  To  Cash. .  .|  C.J.I  |35i00||july  31  By  Profit  and  Loasl.  .|     |35|00 

The  Profit  and  Loss  Account. — There  now  remain  open  in  the 
Ledger  only  the  real  accounts,  with  the  possible  exception  of  the 


40 


ACCOUNTS  IN  THEORY  AND  PRACTICE 


profit  and  loss  account,  which  stands  debited  and  credited  with 
the  various  nominal  items  that  have  been  closed  into  it.  It  may 
or  may  not  appear  in  the  Ledger.  It  might  not  be  desirable  to 
open  this  account  in  the  Ledger  because  of  the  important  in- 
formation which  it  contains.  For  illustrative  purposes  it  may 
be  opened  in  the  Ledger.  The  profit  and  loss  account  appears 
thus  after  the  closing  entries  are  posted: 

Profit  and  Loss 


1917 

July 


31 


To  Purchases . . 

To  Inventory 
(Old) 

To  Stable  Sup- 
plies   

To  Rent  Ex- 
pense   

To  Misc.  Ex- 
pense   

To  Wages  Ex- 
pense   

To  Fuel  and 
Light  Expense 

Balance,  Net 
Profit  Carried 
to  Capital. .  . 


1,550 

30 

1917 

July 

1 
31 

5,000 

00 

20 

00 

35 

00 

22 

57 

140 

00 

6 

60 

207 

72 

6,981 

19 

By  Sales .... 
By    Inventory 
(New) 


1,581 
5,400 


6,981 


19 
00 


19 


Disposition  of  Net  F*rofit. — The  account  shows  a  credit  balance 
of  $207.72,  which  is  the  net  profit  made  by  Grant  Atkins  during 
the  month  of  July.  This  means  that  his  net  worth  or  capital 
has  been  increased  by  that  amount.  It  is  customary  to  show 
the  increased  or  decreased  capital  by  carrying  the  balance  of  the 
profit  and  loss  account  to  the  proprietor's  capital  account.  This 
may  be  done  by  a  final  closing  entry,  as  follows: 


Profit  and  Loss $207.72 


$207.72 


To  Grant  Atkins  Capital 

To  transfer  profit  for  month  to  capital  account. 

When  this  entry  is  posted  the  profit  and  loss  account  is  closed, 
as  shown  above,  and  the  capital  account  of  Grant  Atkins 
becomes: 


INTERPRETATION  OF  LEDGER  ACCOUNTS  41 

Grant  Atkins — Capital 
1017 

By  Sundries Jl       22,500.00 

By  Profit  and  Loss . .  J  ( ?)  207 .  72 

This  capital  account  may  be  permitted  to  stand  as  above  or, 
if  desirable,  it  may  be  ruled  off  and  the  balance  brought  down  as 
shown  below: 

Grant  Atkins — Capital 

1917  1917 

July  31,  To  Balance.  July    l,By  Sundriesll.  . .    22,500.00 

Net  Capital 22,707.72      July  31,  Profit  and  Loss  J(?)      207.72 

22.707.27  22.707.72 

Aug.  1,      By  Balance,  Net  Capital,     22,707.72 

The  Final  Trial  Balance. — Another  trial  balance  should  now 
be  taken  of  the  Ledger.  This  is  known  as  the  final  trial  bal- 
ance. The  final  trial  balance  shows  the  amount  of  the  assets, 
liabilities  and  capital  after  a  period's  transactions — in  this  case 
one  month.  All  open  accounts  shown  in  the  final  trial  balance 
are  real  accounts.  Sometimes  the  final  trial  balance  is  termed 
the  "balance  sheet,"  but  it  is  better  to  apply  this  expression  to  a 
rearrangement  of  the  items  listed  in  the  final  trial  balance.  In 
this  rearranged  statement  items  of  like  character  are  listed  under 
suitable  subheads,  as  shown  below : 

Balance  Sheet,  Grant  Atkins,  as  at  July  31,  1917 

Assets  Liabilities  and  Capital 

Fixed  Assets  Fixed  Liabilities 

StoreandLot $9,000.00         None $       00.00 

Furniture  and 

Fixtures 500.00 

Current  Assets  Current  Liabilities 

Cash 8,110.52         Accounts  Payable. ..  .  425.00 

Accounts  Receivable. .  102 .  20 

Inventory,  July  31 .  . .       5,400 . 00 
Deferred  Charges  Capital 

Stable  Supplies 20. 00         Grant  Atkins 22,707 . 72 

$23,132.72  $23,132.72 

The  profit  and  loss  account  may  also  be  put  into  a  form  more 
intelligible  to  the  individual  unacquainted  with  accounts.  It 
is  then  termed  "profit  and  loss  statement,"  or  "income  state- 


42  ACCOUNTS  IN  THEORY  AND  PRACTICE 

ment."  Below  is  shown  a  profit  and  loss  statement  for  the 
business  of  Grant  Atkins  for  the  month  ending  July  31,  1917. 
This  should  be  carefully  compared  with  the  profit  and  loss  ac- 
counts given  above,  and  the  rearrangement  of  the  items  noted. 

Profit  and  Loss  Statement,  Grant  Atkins,  for  the  Month  Ending  July  31, 1917 

Sales  for  Month $1,.581 .  19 

Deduct  Cost  of  Goods  Sold : 

Inventory,  July  1 $6,000.00 

Purchases  During  Month 1,550 .  30 

$6,550.30 
Less:  Inventory  July  31 5,400.00    $1,150.30 

Gross  Profit  on  Sales $    430.89 

Deduct  Expenses  of  Operation: 

Rent $      35.00 

Wages 140.00 

Fuel  and  Light 5 .  60 

Stable  Supplies 20.00 

Miscellaneous 22.57     $    223.17 

Net  Profit  for  Month $    207.72 

Process  of  Ledger  Interpretation. — Thus  we  find  that  the 
interpretation  of  the  Ledger  includes  six  distinct  steps: 

1.  Taking  the  trial  balance. 

2.  Entering  the  closing  journal  entries  and  posting  them,  thus 
closing  the  nominal  accounts  and  setting  up  the  profit  and  loss 
account. 

3.  Closing  the  balance  of  the  profit  and  loss  account  (net 
profit)  into  the  capital  account. 

4.  Taking  the  final  trial  balance. 

5.  Rearranging  the  profit  and  loss  account  into  the  profit  and 
loss  statement. 

6.  Rearranging  the  final  trial  balance  into  the  balance  sheet. 
The  Financial  Statements. — The  profit  and  loss  statement  and 

the  balance  sheet  are  the  ends  toward  which  all  preceding  work 
is  the  means.  They  interpret  the  ledger,  each  performing  a 
distinct  part  of  that  work.  The  profit  and  loss  statement  details 
the  expenses,  losses,  and  profits.  The  balance  sheet  shows  the 
amount  of  all  assets  and  liabilities  and  the  net  worth  or  proprie- 
torship. It  indicates  the  financial  condition  of  an  enterprise  at 
a  given  instant  of  time,  presenting  a  kind  of  cross-sectional  view 
of  it. 


INTERPRETATION  OF  LEDGER  ACCOUNTS  43 

The  profit  and  loss  statement  and  the  balance  sheet  are  the 
two  most  essential  documents  issued  to  afford  material  for  the 
study  of  the  history  and  progress  of  an  enterprise.  Unincor- 
porated concerns,  such  as  sole  proprietorships,  do  not  usually 
publish  these  statements  but  keep  the  information  they  supply 
more  or  less  private.  Their  value  is  largely  comparative.  That 
is,  if  a  system  of  accounts  is  continued  for  several  years,  useful 
comparative  statements  can  be  constructed,  showing  changes 
and  tendencies,  and  thus  affording  checks  to  extravagant  and 
misdirected  projects.  The  usefulness  of  the  information  sup- 
plied by  the  Ledger  is  conditioned  largely  upon  its  timeliness. 
Next  to  accuracy  of  results  timehness  is  the  most  important 
requirement. 

The  Month  as  the  Accounting  Period. — Formerly,  and  even 
today  in  some  instances,  the  nominal  accounts  were  closed  out 
at  irregular  and  infrequent  intervals.  Modern  conditions  re- 
quire the  customary  financial  statements  frequently,  regularly, 
and  promptly.  The  month  has  become  the  most  popular  period 
of  time  upon  which  to  base  these  statements.  It  is  not  so  long 
but  that  any  unfavorable  tendencies  can  be  discovered  before 
much  injury  results  from  them.  It  is  sufficiently  long  to  allow 
influences  and  tendencies  to  materialize  considerably,  to  make 
an  interpretation  of  them  reliable,  and  yet  not  interfere  too 
much  with  daily  oflUce  routine  by  the  additional  labor  entailed. 


CHAPTER  VII 
RECORDING  FINANCIAL  TRANSACTIONS— PRACTICE 

Purpose  of  Practice  Chapters. — If  the  student  has  grasped 
thoroughly  the  contents  of  the  preceding  chapters  he  is  now  pre- 
pared to  confirm  these  fundamental  principles  and  fix  them  in 
mind  by  the  exercises  that  follow  in  this  chapter.  The  per- 
formance of  these  problems  in  a  careful  and  thoroughgoing 
manner  is  as  necessary  to  the  successful  study  of  accounting 
as  is  a  study  of  the  theory  that  underlies  them.  It  is  for  this 
reason  that  separate  practice  chapters  have  been  given  equal 
emphasis  along  with  those  that  are  given  over  to  an  exposition 
of  principles. 

Character  of  Practice  Work. — If  this  practice  work  is  to  do 
the  greatest  possible  good  the  student  must  be  self-reliant, 
attempting  at  every  stage  to  catch  the  full  significance  of  all 
transactions  and  to  apply  the  principles  explained  in  the  chapters 
treating  of  the  theory.  In  no  instance  will  practice  problems 
anticipate  theory;  but  in  every  instance  there  will  be  found  in 
preceding  chapters  an  exposition  adequate  to  enable  the  student 
to  proceed  intelligently  with  the  problem.  Practice  problems 
found  in  later  practice  chapters  illustrate  not  only  the  chapter 
on  theory  immediately  preceding  but  will  frequently  be  found 
to  be  dependent  on  earlier  theory  chapters,  thus  affording  con- 
tinuous review  exercises. 

Materials  Required — Construction  of  Books. — The  student 
should  supply  himself  with  a  small  quantity  of  ordinary  journal 
and  ledger  paper.  For  the  exercises  in  this  chapter  two  double 
sheets  of  ledger  paper  and  two  double  sheets  of  journal  paper 
will  suffice.  As  more  will  be  needed  it  will  be  best  to  buy  it  in 
quantities  of  not  less  than  six  sheets  of  each.  He  is  now  ready 
to  construct  the  General  Journal,  Cash  Journal  and  Ledger. 
On  the  first  page  of  journal  paper  make  the  notations  shown  in 
the  following  diagram : 

44 


RECORDING  FINANCIAL  TRANSACTIONS 


45 


Page  1. 
General  Journal,  A.  B.  Gray 

Date                             Explanation                             F        Dr.            Cr. 

1919 

i             1     1 

i 

Note  the  page  number,  location  in  center  of  page  of  the  title 
"General  Journal,"  the  date,  "1919,"  and  the  designations 
"Dr."  and  " Cr."  at  the  top  of  the  first  and  second  money  columns 
respectively.  If  the  column  headed  "F"  is  lacking  it  should 
be  supplied  by  the  student. 

Next  construct  a  Cash  Journal  by  opening  a  sheet  of  Journal 
Paper  and  making  therein  the  notations  shown  in  the  following 
diagram : 


46 


ACCOUNTS  IN  THEORY  AND  PRACTICE 


^     3 

Pk    i 

^ 

6 

1 

O 

M 

an 

«i   a 

^.2 

•4^ 

O 

s 

08 

•H-t 

o. 

M 

» 

>. 

« 

ti 

o 

03         „, 

tM         « 

o> 

•a 

s 

a 

1       § 

►2.      S 

ash 

Colu 

u 

•*» 

1 

Q 

M 

CO 

^.i 

'■♦3 

§ 

' 

cS 

■o. 

« 

H 

age  1 
Date 

Ph 

"^ 

RECORDING  FINANCIAL  TRANSACTIONS  47 

Note  that  "Page  1"  is  entered  on  both  sides  of  the  double 
page.  Note  also  the  location  of  the  "F"  or  folio  columns, 
which  should  be  suppUed  if  lacking. 

Lastly,  take  a  double  sheet  of  ledger  paper  and  on  the  first 
page  enter  the  following  notations : 


Page  1 
Ledger,  A.  B.  Gray 
Date      Explanation      F       Amt.        Date      Explanation     F       Ami. 

' 

1 

, 

Having  finished  the  first  page  of  the  Ledger  open  the  sheet  and 
make  the  same  notations  on  the  inner  left  hand  page,  then  on  the 
inner  right  hand  page,  and  finally  on  the  outer  or  fourth  page, 
but  paging  them  respectively  "Page  2,"  "Page  3,"  and  "Page  4." 

You  are  now  ready  to  enter  the  transactions  of  A.  B.  Gray 
for  the  month  of  September,  as  follows: 

Diary  of  Events — A.  B.  Gray — Sept.,  1919. 

Sept.  1,  1919.  A.  B.  Gray  enters  the  retail  grocery  business,  investing 
$4,000  in  cash.  Pays  Sept.  rent  $50.00.  He  pays  $400.00  for  a  horse 
and  delivery  wagon,  and  engages  Andy  Smith  as  a  delivery  boy  at  $30.00  per 
month.  He  also  engages  a  clerk  at  $50.00  per  month  and  a  bookkeeper  at 
$60.00.  These  persons  begin  work  as  of  Sept.  1,  and  are  to  receive  payment 
semi-monthly. 

Note. — The  opening  entry  should  be  made  in  both  Journal 
and  Cash  Book.  Ordinarily  cash  items  do  not  appear  in  the 
Journal  and  it  would  not  be  wrong  in  this  instance  to  enter 
the  $4,000.00,  original  investment,  in  the  Cash  Journal  and  omit 
it  from  the  General  Journal.  Since,  however,  it  is  customary 
to  show  the  original  investment  entry  in  the  Journal  it  is  best 


48 


ACCOUNTS  IN  THEORY  AND  PRACTICE 


to  enter  it  in  both  General  Journal  and  Cash  Journal  but  checked 
thus(  1/  )  in  the  General  Journal  folio  column  to  indicate  that  it  is 
to  be  posted  from  the  Cash  Journal.  This  entry  then  appears 
thus  in  General  Journal  and  Cash  Journal: 


General  Journal 


Date 

Explanation 

F 

Dr. 

Cr 

1919 

Sept 

1 

A.  B.  Gray  this  day  enters  the  retail  grocery 

business  with  assets  and  capital  as  follows 
Cash 

v^ 

4,000 

00 

A.  B.  Gray,  Capital 

4,000  00 

Date 


Cash  Journal  (left  page) 
Explanation 


F      Amt.  columns 


1919 


Sept.    Ij  A.  B.  Gray,  Capital. 


4,000  00 


The  payments  of  $50.  Sept.  rent  and  $400  for  horse  and  wagon 
are  next  made  on  the  right  side  of  the  Cash  Book,  thus: 


Date 


Cash  Journal  (right  page) 
Explanation 


Amt.  columns 


1919 

Sept. 


Expense — Sept.  rent 

Delivery  Equipment — horse  and  wagon. 


6000 
400  00 


The  remainder  of  the  data  for  Sept.  1  is  mere  memoranda 
and  should  not  be  entered  in  the  books. 

Sept.    2.     Buys  from   Cloverdale   Wholesale    Co.   mdse.     $500.00,   on 
account,  30  days. 

Note. — Make  this  entry  in  the  Journal  immediately  below 
the  one  for  Sept.  1,  as  follows: 

Sept.  2     Purchases $500. 00 

Cloverdale  Wholesale  Co $500 .  00 

On  acct.  30  da. 


RECORDING  FINANCIAL  TRANSACTIONS  49 

Sept.  3.  Sells  to  T.  M.  Phillips,  on  account,  mdse.  $8.75,  and  to  Andrew 
Fry,  on  account,  mdse.,  $11.43. 

Note. — These  entries  are  made  in  the  General  Journal, 
as  follows : 

Sept.  3    T.  M.  Phillips $8. 75 

Sales $8.75 

Andrew  Fry $11 .  43 

Sales $11.43 

Since  all  transactions  on  account  appear  in  the  General  Journal 
and  since  time  of  credit  granted  is  not  given  no  explanation 
need  be  appended  to  these  entries. 

Sept.  5.  He  buys  a  display  case  for  his  store  window  from  the  Oldmore 
Manufacturing  Co.,  on  account,  10  days,  $50.00. 

Note. — This  is  a  General  Journal  entry.  Why?  Charge 
"Furniture  and  Fixtures"  and  credit  " Oldmore  Manufacturing 
Co.,"  making  an  explanation,  beneath  the  entry,  of  the  nature  of 
the  transaction,  thus: 

Furniture  and  Fixtures $50.00 

Oldmore  Manufacturing  Co $50 .  00 

For  display  case  bought  on  acct.  10  da. 

The  student  will  learn  that  accountants  possess  a  variety  of 
stereotyped  phrases  which  conveniently  express  classes  of  assets, 
liabilities,  losses,  etc.  Among  these  are  Furniture  and  Fixtures, 
Delivery  Equipment,  Supplies,  Accounts  Receivable,  Accounts 
Payable,  Profit  and  Loss,  and  so  on.  The  full  significance  of 
these  will  appear  as  we  proceed. 

Sept.  6.  Sells  mdse.  for  cash  $15.22,  and  to  S.  Thomas,  on  account, 
mdse.,  $7.27. 

The  cash  sale  is  entered  on  the  left  side  of  the  Cash  Journal 
thus: 

Sept.  6     Sales $15.22 

The  amount  should  appear  in  the  first  money  column. 

For  S.  Thomas,  see  transactions  on  Sept.  3. 

Sept.  8.  Cash  sales  $10.03.  Buys  2  tons  hay  for  delivery  horse,  $30.00, 
cash. 

For  the  first  transaction  see  Sept.  6.  For  2  tons  hay  bought  make  follow- 
ing entry  on  right  side  of  Cash  Journal: 

Sept.  8    Supplies— 2  tons  hay $30. 00 

Sept.  9.  Cash  sales,  $22.11.  Sells  on  account,  mdse.,  to  T.  M.  Phillips 
$6.42;  to  R.  T.  Myers,  $7.00;  and  to  B.  L.  McLoughlin,  $3.25.  (See  entries 
of  Sept.  3  and  6.)     T.  M.  Phillips  pays  bill  of  Sept.  3,  $8.75. 

4 


50  ACCOUNTS  IN  THEORY  AND  PRACTICE 

The  sales  on  account  will  be  understood  by  turning  to  the 
entries  referred  to  in  parentheses.  Hereafter  when  entries  similar 
to  those  already  made  are  met  with  the  only  explanation  will 
be  the  reference  to  the  preceding  entry.  The  entry  for  T.  M. 
Phillips  is  made  on  the  left  side  of  the  Cash  Journal  thus: 

Sept.  9     T.  M.  Phillips— bill  of  Sept.  3 $8. 75 

Sept.  10.     Gray  pays  telephone  bill  for  Sept.,  $3.00  (see  Sept.  1).     Sells 

to  J.  J.  Tiery,  on  account,  mdse.,  $6.00  (see  Sept.  9).     Buys  mdse.,  on 

account,  30  days,  from  Cloverdale  Wholesale  Co.,  $400.00  (see  Sept.  2). 

Cash  sales,  $22.35  (see  Sept.  8). 

Sept.  11.     Pays  Oldmore  Manufacturing  Co.  bill  of  Sept.  5,  $50.00.     Cash 

sales,  $24.00  (see  Sept.  9).     Pays  $10.00  for  advertising  and  $5.00  for 

sign  painting  on  store.     (See  entry  for  rent,  Sept.  1.) 

Note. — The  payment  to  Oldmore  Mfgr.  Co.  is  entered  on  the 
right  side  of  the  Cash  Journal,  thus: 

Sept.  11     Oldmore  Manufacturing  Co.  bill  Sept.  5 $50. 00 

Sept.  12.     Cash  sales,  $30.00  (see  Sept.^  11). 

Sept.  13.  S.  Thomas  pays  bill  Sept.  6,  $7.27.  (See  Sept.  9.)  R.  T. 
Myers  pays  bill  of  Sept.  9,  $7.00  (see  Sept.  9).  Pays  assistants  their  first 
half -month's  salaries  as  follows: 

Delivery  boy $15.00 

Clerk 25.00 

Bookkeeper 30. 00 

He  also  withdraws  $40.00  for  personal  use. 

Note.  —  Enter  payment  of  salaries  on  right  side  of  Cash  Journal 
thus: 

(  Delivery  boy $15.00 

Sept.  13  Expense ]  Clerk 25.00 

I  Bookkeeper 30. 00  $70. 00 

The  salaries  are  itemized  in  the  explanation  column  and  the 
total  extended  into  the  first  money  column. 

Enter  withdrawal  of  cash  on  right  side  of  Cash  Journal  thus: 

Sept.  13     A.  B.  Gray,  Withdrawals $40.00 

Sept.  15.  Cash  sales,  $35.00  (see  Sept.  12).  Andrew  Fry  pays  bill  of 
Sept.  3,  $11.43  (see  Sept.  9). 

Sept.  16.  Cash  sales,  $40.00  (see  Sept.  15).  Sells  on  account  to  S. 
Thomas,  $14.00;  to  T.  M.  Phillips,  $8.00;  to  R.  T.  Myers,  $5.20  (see  Sept. 
10). 

Sept.  17.  Buys  mdse.  from  Cloverdale  Wholesale  Co.,  $150.00,  on 
account,  2%  10  days,  net  30  days  (see  Sept.  10).  Cash  sales,  $37.70. 
(See  Sept.  16.) 


RECORDING  FINANCIAL  TRANSACTIONS  51 

Sept.  18.  T.  M.  Phillips  gives  note,  due  in  10  days,  in  payment  of  bill 
of  Sept.  9.  Cash  sales,  $40.00  (see  Sept.  17).  Pays  $10.00  for  repairs 
on  store  (see  Sept.  11). 

Note. — Notes  are  sometimes  given  in  payment  of  an  account. 
When  this  is  done  the  personal  account  of  the  giver  is  credited 
and  "Notes  Receivable"  charged.  This  entry  is  made  in  the 
General  Journal  thus: 

Sept.  18.     Notes  Receivable $6. 42 

T.  M.  PhiUips $6.42 

Note  due  in  10  da.  in  payment  of  bill  of  Sept.  9. 

Sept.  19.  Sells  on  account  to  D.  Hathaway,  mdse.  $7.20;  to  R.  T.  Myers, 
$3.20  (see  Sept.  16).     Buys  6  chairs  for  store,  cash,  $30.00  (see  Sept.  5). 

Sept.  20.  Cash  sales,  $45.00  (see  Sept.  18).  Buys  mdse.  from  Cloverdale 
Wholesale  Co.,  $600.00,  2%  10  days,  net  30  days  (see  Sept.  17). 

Sept.  22.  Sells  mdse.  to  S.  Adams,  $15.00.  Adams  gives  note  for  30 
days  for  purchases.  Cash  sales,  $28.50  (see  Sept.  20).  Miscellaneous 
expense,  $4.25  (see  Sept.  11).     Stationery  and  postage,  $9.50  (see  Sept.  11). 

Note. — Charge  S.  Adams  and  credit  Sales  as  in  any  charge 
account.  Then  in  the  General  Journal  charge  Notes  Receivable 
and  credit  S.  Adams,  thus: 

S.  Adams $15.00 

Sales $15.00 

Notes  Receivable $15.00 

S.  Adams $15.00 

Note  due  in  30  da. 

Sept.  23.  Cash  sales,  $33.20  (see  Sept.  22).  B.  L.  McLoughlin  pays  bill 
of  Sept.  9,  $3.25  (see  Sept.  15).  Takes  $10.00  from  cash  drawer  for  personal 
use  (see  Sept.  13).  Sells  on  account  to  B.  Ward,  mdse.,  $5.00;  D.  Hathaway, 
mdse.,  $11.60;  R.  T.  Myers,  $15.00  (see  Sept.  19). 

Sept.  24.     Cash  sales,  $30.27  (see  Sept.  23). 

Sept.  25.     Cash  sales,  $33.15  (see  Sept.  24). 

Sept.  27.  Pays  Cloverdale  Wholesale  Co.  bill  of  Sept.  17,  less  discount. 
Cash  sales,  $40.00  (see  Sept.  25). 

Note. — Enter  the  net  cash  payment  on  the  right  side  of  the 
Cash  Journal,  thus: 

Cloverdale  Wholesale  Co.  (— )  bill  Sept.  17 $147.00 

In  the  Journal  charge  Cloverdale  Wholesale  Co.  and  credit 
Discount  on  Purchases  thus: 

Cloverdale  Wholesale  Co $3 .  00 

To  Discount  on  Purchases $3 .  00 

For  discount  taken. 
Sept.  28.     T.    M.   Phillips  pays  note  due  today.     Cash  sales,  $43.77 
(see  Sept.  27). 


52  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Note. — Charge  cash  and  credit  Notes  Receivable  on  the  left 
side  of  the  Cash  Book  thus: 

Sept.  28.     Notes  Receivable— T.  M.  Phillips S6. 42 

Sept.  30.  Cash  sales,  $35.00  (see  Sept.  28).  Pays  assistants  as  follows: 
(see  Sept.  13) 

Delivery  boy $15.00 

Clerk 25.00 

Bookkeeper 30. 00 

D.  Hathaway  pays  his  account  in  full  (see  Sept.  23).  Mr.  Gray,  wishing 
to  know  the  results  of  the  month's  transactions,  takes  inventory,  finding 
that  it  amounts  to  $513.00.  You  are  instructed  to  draw  up  a  statement 
showing  profit  or  loss  for  the  month. 

Note. — First,  however,  it  will  be  necessary  to  post  from  the 
General  Journal  and  Cash  Journal  to  the  Ledger.  Ordinarily 
this  posting  is  done  day  by  day.  Here  we  have  first  made  all 
entries  in  the  General  Journal  and  Cash  Journal.  Two  double 
sheets  of  ledger  paper  will  suffice  for  the  Ledger.  Page  it  1,  2, 
3,  4,  and  so  on.     Open  accounts  as  follows: 

Page  1: 

Line    1  A.  B.  Gray,  Capital 

Line    6  A.  B.  Gray,  Withdrawals 

Line  20  Cash 

Page  2: 
Line    1    Purchases 
Line    9    Sales 

Page  3: 

Line    1  T.  M.  Phillips 

Line  10  Andrew  Frey 

Line  20  S.  Thomas 

Line  30  R.  T.  Myers 

Page  4: 

Line    1  B.  D.  McLaughUn 

Line  10  J.  J.  Tiery 

Line  20  D.  Hathaway 

Li6e  30  S.  Adams 

Line  35  B.  Ward 

Page  5: 
Line    1    Cloverdale  Wholesale  Co. 
Line  10    Oldmore  Manufacturing  Co. 

Page  6: 

Line    1  Discount  on  Purchases 

Line  10  Wages  and  Salaries 

Line  20  Expense 

Line  30  Supplies 


RECORDING  FINANCIAL  TRANSACTIONS  53 

Page  7: 

Line    1  Furniture  and  Fixtures 

Line  10  Notes  Receivable 

Line  20  Delivery  Equipment 

Page  8: 
Line    1    Profit  and  Loss 

Following  the  principles  and  illustrations  in  Chapter  VI, 
post  from  the  General  Journal  and  Cash  Journal  to  the  Ledger. 
Note  that  items  appearing  on  the  debit  side  of  the  Cash  Journal 
are  posted  to  the  credit  side  of  the  Ledger  and  vice  versa.  This 
is  because  items  appearing  on  the  left  side  are  credits  to  the 
account  appearing  in  the  explanation  columns  and  a  charge  to 
cash.  Cash,  however,  is  posted  only  in  total  at  the  end  of  the 
month.  Similarly,  accounts  appearing  in  the  explanation 
column  on  the  credit  side  are  to  be  charged  while  the  cash  credit 
is  posted  in  total  at  the  end  of  the  month. 

When  all  postings  are  made  see  that  all  cross  references  have 
been  inserted  in  the  folio  columns.  Next  prepare  a  trial  balance 
of  the  Ledger.     This  should  agree  with  the  following: 

Trial  Balance— A.  B.  Gray— as  at  Sept.  30,  1910 

A.  B.  Gray,  Capital $4,000.00 

Purchases $1,650.00 

Sales 699.62 

Cash 3,689.47 

T.  M.  Phillips 8.00 

S.  Thomas 14.00 

R.  T.  Myers 23.40 

J.  J.  Tiery 6.00 

B.  Ward 5.00 

Cloverdale  Wholesale  Co 1,600.00 

Discount  on  Purchases 3 .  00 

Wages  and  Salaries 140 .  00 

Expense 91.75 

Supplies 30.00 

Furniture  and  Fixtures 80. 00 

Notes  Receivable 15 .  00 

Dehvery  Equipment 400. 00 

A.  B.  Ciray,  Withdrawals 50.00 


$6,202.62  $6,202.62 

Assume  that  3^  of  the  supplies  have  been  consumed.     Make 
closing  entries  in  the  General  Journal  and  carry  net  profit  or  loss 


54  ACCOUNTS  IN  THEORY  AND  PRACTICE 

to  A.  B.  Gray's  withdrawal  account  and  the  balance  of  with- 
drawals to  capital.  Note  that  there  is  no  old  inventory  as  in  case 
of  Grant  Atkins  explained  in  Chapter  V.  Bring  down  balance 
of  A.  B.  Gray's  capital  account  as  of  Oct.  1.  Set  up  balance 
sheet  and  profit  and  loss  statement.  Gray's  capital  as  of  Oct. 
1  should  be  $3,326.37. 


CHAPTER  VIII 
RECORDING  FINANCIAL  TRANSACTIONS— PRACTICE 

Dairy  of  Events— A.  B.  Gray— Oct.  1919. 

Oct.  1.  Begin  month  by  opening  new  books — General  Journal,  Cash 
Journal  and  Ledger.  The  Journal  should  contain  8  pages,  the  Cash  Journal 
two  double  pages  (composed  of  2  double  sheets  of  journal  paper),  and  the 
Ledger  24  pages  (composed  of  6  double  sheets  of  ledger  paper).  Page  these 
books.  Accounts  should  be  opened  in  the  Ledger  as  follows:  p.  1 — at  top, 
A.  B.  Gray,  Capital;  p.  2 — at  top,  Furniture  and  Fixtures;  at  middle, 
Delivery  Equipment;  p.  3 — at  top,  Purchases;  at  middle.  Sales;  p.  4 — at  top, 
Cash;  at  middle.  Notes  Receivable;  p.  5 — at  top,  notes  Payable;  p.  13 — at 
top,  T.  M.  Phillips;  at  middle,  S.  Thomas;  p.  14 — at  top,  R.  T.  Myers;  at 
middle,  J.  J.  Tiery ;  p.  15 — at  top,  B.  Ward;  p.  20 — at  top,  Cloverdale  Whole- 
sale Co. 

Using  the  balance  sheet  of  A.  B.  Gray  as  at  Sept.  30,  1919,  as  a  basis, 
make  the  opening  Journal  entry  for  Oct.  1,  1919,  in  the  new  Journal,  making 
the  proper  preliminary  explanation  in  the  Journal,  to  the  effect  that  A.  B. 
Gray  opens  new  books  with  assets,  liabilities  and  capital  brought  from  the 
old  books,  as  shown. 

Note.— In  the  Cash  Journal  designate  the  two  debit  columns 
" Sales "  and  "Sundries,"  respectively,  and  the  two  credit  columns 
"General  Expense"  and  "Sundries,"  respectively. 

Cash  sales  $47.20.  Advertising  paid  in  advance  for  month,  $15.00 
(charge  to  Expense,  opening  account  in  Ledger  page  5,  at  middle).  Pays 
Cloverdale  Wholesale  Co.  bill  of  Sept.  2,  $500.00. 

Note. — Charge  Purchases  account  for  all  purchases  of  mer- 
chandise made  and  credit  Sales  account  for  all  sales  of  mer- 
chandise. To  enter  "Cash  sales  $47.20"  in  the  Cash  Journal 
write  "Sales"  in  the  explanation  column  and  enter  the  amount, 
$47.20,  in  the  "Sales "  column.  All  cash  sales  should  be  similarly 
entered.  For  advertising  paid,  charge  "Advertising  Expense" 
and  enter  the  amount  $15.00,  in  the  "General  Expense"  colunm. 
Hereafter  enter  all  expen.se  items  in  the  "General  Expense" 
column  unless  a  special  account  is  required,  as  in  case  of  "In- 
surance" paid  for  on  Oct.  6  (see  below),  in  which  case  it  should 
be  taken  into  "Sundries"  column. 

55 


56  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Oct.  2.  Cash  sales,  $43.00.  Sells  mdse.  on  account  to  M.  Harris,  S19.30 
(Ledger  p.  15),  to  S.  Thomas,  on  account,  $10.00.  Pays  rent  for  October, 
$50.00  (General  Expense). 

Oct.  3.  Buys  from  Cloverdale  Wholesale  Co.,  on  account,  mdse.  $500, 
2%  10  days,  net  30  days.     Cash  sales  $53.20. 

Oct.  4.  Takes  out  insurance  on  merchandise,  paying  premium  for  1  year, 
$12.00  (Insurance,  Ledger,  p.  6,  top).     Cash  sales,  $43.47. 

Oct.  6.  Mr.  Gray  purchases  the  store  in  which  he  is  located  for  $5,000.00. 
The  rent  paid  for  Oct.  is  to  be  counted  in  part  payment.  Cash  is  paid 
amounting  to  $1,950,  and  a  mortgage  at  6%,  interest  payable  annually,  is 
given  for  the  balance.  (Store  and  Lot,  p.  6,  middle;  Mtge.,  p.  7,  top.) 
Cash  sales,  $40.00. 

Note. — In  the  Cash  Journal  charge  Store  and  Lot  for  $1,950, 
and  in  the  General  Journal  charge  Store  and  Lot  $3,050,  crediting 
Expense,  $50,  and  Mortgage,  $3,000.  Make  proper  explanation 
following  the  entry,  covering  the  expense  adjustment,  the  mort- 
gage, and  the  terms  thereof. 

Oct.  7.  Mr.  Gray  makes  a  loan  of  $1,000  to  B.  Arthur,  receiving  therefor 
Mr.  B.  Arthur's  note  for  20  days,  with  interest  at  6%.  Cash  sales  $42.00. 
Sold  to  J.  J.  Tiery,  on  acct.,  mdse.  $12.10. 

Note. — For  the  loan  to  B.  Arthur  charge  "Notes  Receivable" 
indicating  "from  B.  Arthur"  in  the  explanation  column  in  the 
Cash  Journal,  thus: 

Notes  Receivable — from  B.  Arthur $1,000 

putting  the  amount  in  the  "Sundries"  column,  right  side  of  the 
Cash  Book. 

Oct.  8.  R.  T.  Myers,  one  of  Mr.  Gray's  customers,  has  made  an  assign- 
ment in  bankruptcy,  and  after  his  business  has  been  liquidated  he  has  paid 
his  unsecured  creditors  at  the  rate  of  67  cents  on  the  dollar.  Mr.  Myers 
owes  Mr.  Gray  $23.40.  Mr.  Gray  receives  cash  from  Mr.  Myers  on  above 
basis  (Bad  Debts,  p.  7,  middle).     Cash  sales,  $45.00. 

Note. — In  the  Cash  Journal  credit  R.  T.  Myers  with  the 
amount  he  is  able  to  pay.  In  the  General  Journal  charge  Bad 
Debts  and  credit  R.  T.  Myers  for  the  loss  resulting  from 
bankruptcy. 

Oct.  9.  Mr.  Gray  buys  a  barn  and  storage  house  for  $2,000.  He  gives 
a  mortgage  for  $1,000,  at  6%,  for  4  yrs.,  interest  payable  annually,  and 
pays  the  balance  in  cash.  As  he  has  not  sufficient  cash  on  hand  to  make 
the  payment,  he  discounts  his  note,  payable  in  30  days,  at  a  bank;  face 
$200;  proceeds  $198.  (Interest,  p.  8,  at  top.)  Cash  sales,  $40.00.  B. 
Ward  pays  his  account  in  full.     J.  J.  Tiery  pays  his  account  in  full. 


RECORDING  FINANCIAL  TRANSACTIONS  57 

Note. — Enter  the  mortgage  in  the  General  Journal,  crediting 
"Mortgage"  and  charging  "Barn  and  Storage  House"  (Ledger, 
p.  8).  The  discounted  note  may  be  handled  in  either  of  two 
ways: 

(a)  By  charging  Cash  and  crediting  Notes  Payable  for  $200  on  the  receipt 
side  of  the  Cash  Journal  and  then  charging  Interest  and  crediting  Cash 
on  the  payments  side  for  $2;  or, 

(6)  By  charging  Cash  and  crediting  Notes  Payable  for  S198  in  the 
receipts  side  of  the  Cash  Journal  and  by  charging  Interest  and  crediting 
Notes  Payable  in  the  General  Journal. 

It  is  suggested  that  the  latter  method  be  followed  here. 

Oct.  10.  Cash  sales,  $40.50.  Pays  Cloverdale  Wholesale  Co.  bill  of 
Sept.  10. 

Oct.  11.  Sells  on  acct.  to  M.  Arnold,  mdse.,  $14.00;  to  T.  M.  Phillips, 
$5.20;  to  S.  Thomas,  $7.33.  Cash  sales,  $43.15.  Pays  telephone  bill  for 
Oct.,  $3.00. 

Oct.  13.  Pays  Cloverdale  Wholesale  Co.  bill  of  Oct.  3,  less  discount 
(Disct.  on  Purchases,  p.  8,  middle).  Cash  sales,  $38.50.  Sells  on  acct., 
mdse.  to  L.  Floyd,  $13.73  (p.  15);  to  S.  Smith,  $2.11  (p.  16);  to  B.  Ward, 
$3.33;  to  the  Brighton  Club,  $14.00  (p.  16). 

Oct.  14.     Cash  sales,  $63.50.     Pays  assistants  as  follows: 

Delivery  boy $18 .  00 

Clerk 30 .  00 

Bookkeeper. 40, 00 

Withdrew  for  personal  use  $40.00  (A.  B.  Gray,  Withdrawals,  p.  1, 
middle).     Charge  wages  of  help  to  "Expense." 

Oct.  15.     Repairs  on  store,  $32.30  (Repairs,  p.  9,  top). 

Oct.  16.  Cash  sales,  $70.00.  Owing  to  increasing  business  Mr.  Gray 
buys  another  horse  and  wagon,  paying  $40  for  the  wagon  and  $150  for  the 
horse.  He  pays  for  the  wagon  in  cash,  and  gives  a  note  payable  in  10 
days  for  the  horse,  to  the  seller,  N.  Norton  (p.  21,  top).  He  engages 
another  delivery  boy  at  $30  per  month. 

Note. — For  the  purchase  of  the  horse  charge  Delivery 
Equipment  and  credit  N.  Norton  in  the  General  Journal;  then 
in  another  Journal  entry  charge  N.  Norton  and  credit  Notes 
Payable.  Reference  to  the  additional  delivery  boy  requires 
no  entry. 

Oct.  17.     Cash  sales,  $75.00. 

Oct.  18.     B.  Ward  pays  acct.  in  full.     Cash  sales  $76.73. 

Oct.  20.  Cash  sales,  $79.00.  Buys  mdse.  of  Cloverdale  Wholesale  Co., 
2/10,  n/30,  $400.00.  Pays  Cloverdale  Wholesale  Co.  bill  of  Sept.  20, 
$600.00. 

Oct.  21.     Buys  grain  for  stable,  $40.00,  cash.     This  is  sufFcient  to  last 


58  ACCOUNTS  IN  THEORY  AND  PRACTICE 

4  mo.  (Stable  Supplies,  p.  9,  middle).  Cash  sales,  $83.00.  Pays  member- 
ship fee  in  Cloverdale  Merchants'  Association,  $6.00  (Exp.). 

Oct.  22.  S.  Adams  pays  note  due  today.  Cash  sales,  $90,00.  On 
acct.  to  T.  M.  Phillips,  $20.00;  to  R.  Story,  $3.40  (p.  17). 

Oct.  23.  Mr.  Gray  has  electric  and  gas  combination  fixtures  placed 
throughout  his  store  at  a  total  cost  of  $175.00.  The  old  fixtures  which 
originally  cost  $50.00  and  were  taken  at  this  figure  when  the  store  was 
bought  are  sold  for  $10  cash.     Cash  sales,  $95.00. 

Note. — Charge  Store  and  Lot  for  the  new  fixtures.  Why 
not  charge  Furniture  and  Fixtures?  Credit  Store  and  Lot  for 
sale  of  old  fixtures.  In  the  General  Journal  charge  Expense  and 
credit  Store  and  Lot  for  loss  incurred  on  old  fixtures. 

Oct.  24.     Cash  sales,  $83.00. 

Oct.  25.  Sells  on  acct.  to  R.  Story,  $5.40;  to  D.  Hathaway,  $3.17.  Cash 
sales,  $88.73. 

Oct.  27.  B.  Arthur  pays  note  today,  with  interest  (20/365  of  1  yr.  for 
int.).     Cash  sales,  $87.20.     Pays  note  due  N.  Norton. 

Note. — Make  separate  entries  for  "Notes  Receivable"  and 
"Interest"  when  B.  Arthur  pays. 

Oct.  28.     Cash  sales,  $90.30. 

Oct.  29.     T.  M.  Phillips  pays  acct.  in  full.     Cash  sales  $89.00. 

Oct.  30.  Cash  sales  $95.00.  Pays  Cloverdale  Wholesale  Co.  bill  Oct. 
20,  less  disc't.  Discounts  note  at  bank,  face  $300;  proceeds  $298.  (15 
days.) 

Oct.  31.    Cash  sales  $100.00.     Pays  assistants: 

Delivery  boy  No.  1 $18.00 

Delivery  boy  No.  2 15.00 

Clerk 30.00 

Bookkeeper 40. 00 

A.  B.  Graj%  desirous  of  knowing  the  results  of  the  month's  trading, 
requests  you  to  present  him  with  a  profit  and  loss  account,  also  a  profit 
and  loss  statement,  and  a  balance  sheet,  after  taking  a  trial  balance  and 
making  the  closing  journal  entries. 

Inventory  Oct.  31 — $1500.  Of  the  Supplies  $15  have  been 
consumed. 

Note. — A.  B.  Gray's  capital  account  as  of  Nov.  1  should  be 
$4,978.24.  Interest  accrued  on  the  mortgages  must  be  taken  into 
the  books  before  making  closing  entries.  Charge  "Interest" 
and  credit  "Interest  Accrued"  in  the  General  Journal.  "In- 
terest" is  a  nominal  account  while  "Interest  Accrued"  is  a  real 
account,  representing  a  deferred  liability. 

Preserve  the  books  of  A.  B.  Gray.  They  will  be  used  to 
record  the  diary  of  events  in  Chapter  XV. 


CHAPTER  IX 

THE  THEORY  OF  ACCRUALS  AND  OF  DEFERRED 
CHARGES 

There  are  certain  kinds  of  expenses  which,  although  incurred 
daily,  are  paid  for  in  cash  only  at  certain,  sometimes  distant, 
intervals.  There  are  also  certain  kinds  of  expenses  which  must 
be  paid  for  in  advance  of  the  time  when  they  are  actually  in- 
curred. These  two  classes  of  expenses  give  rise  to  two  special 
problems  in  accounting  which  may  be  treated  under  the  sub- 
jects, "accruals"  and  "deferred  charges,"  respectively. 

Interest. — Interest  is  an  expense  incurred  for  the  use  of  bor- 
rowed money.  It  sometimes  represents  a  very  permanent  and 
fixed  charge,  as  when  it  is  paid  for  the  use  of  funds  borrowed  on 
mortgage  security.  Sometimes  it  is  a  temporary  expense,  as 
when  it  is  incurred  on  overdue  accounts  payable,  notes  dis- 
counted at  the  bank  to  secure  temporary  advances  of  money, 
etc.  When  money  is  borrowed  on  a  mortgage  the  mortgage  or 
creditor  thereby  secures  a  lien  on  the  real  estate  of  the  mortgagor 
or  borrower.  In  case  the  mortgagor  is  unable  to  pay  the 
interest  on  the  loan  the  mortgagee  may  foreclose  the  mortgage 
and  sell  the  mortgaged  property  for  the  satisfaction  of  both 
interest  and  debt. 

Interest  Periods  Dififer  from  Accounting  Periods. — Interest  is 
reckoned  as  a  percentage  per  annum  on  the  amount  loaned  and 
normally  ranges  from  3  to  7  per  cent,  depending  on  the  safety 
of  the  principal.  When  interest  exceeds  the  legal  rate  it  is 
termed  usury.  Interest  is  paid  at  regular  intervals  which  are 
usually  determined  upon  in  advance  when  the  loan  is  made. 
On  mortgage  indebtedness  interest  is  generally  paid  semiannu- 
ally, at  the  end  of  six-month  intervals.  When  money  is  bor- 
rowed at  a  bank  the  loan  is  customarily  made  for  one  month 
(with  a  renewal  privilege;  consequently  interest  is  then  paid 
monthly.  It  is  readily  seen,  therefore,  that  interest  periods 
and  accounting  periods  will  be  co-tierminous  only  in  exceptional 
cases.     If  the  nominal  accounts  are  closed  at  the  end  of  each 

59 


60  ACCOUNTS  IN  THEORY  AND  PRACTICE 

month  while  interest  payments  are  made  semi-annually,  it 
follows,  that  if  half  a  year's  interest  is  debited  to  profit  and  loss 
as  an  expense  in  that  month  in  which  it  happens  to  fall  due  and 
be  paid,  then  that  month  bears  a  burden  which  ought  to  be 
distributed  over  a  period  of  six  months. 

To  illustrate,  assume  that  on  January  1  a  merchant  borrows 
$6000  for  a  term  of  years,  agreeing  to  pay  5  per  cent  interest 
thereon,  payable  semi-annually  on  December  31  and  June  30. 
Interest  will  amount  to  $300  yearly,  and  each  semi-annual 
instalment  will  amount  to  $150.  Furthermore,  suppose  that 
the  merchant  makes  no  entry  in  his  books  for  interest  until  the 
first  half  year's  instalment  falls  due,  when  he  credits  cash,  $150, 
in  the  Cash  Journal,  and  at  the  same  time  charges  "interest 
expense,"  or  merely  "interest,"  for  the  same  amount.  "In- 
terest" is  a  nominal  or  expense  item,  and  is  closed  into  the  profit 
and  loss  account  for  the  month  ending  June  30.  Clearly  the 
profit  and  loss  account  for  June  is  thus  debited  with  interest  , 
which  should  have  been  pro-rated  over  the  first  six  months  of 
the  year.  The  profit  and  loss  accounts  for  the  preceding  five 
months  have  not  been  charged  with  their  proportion  of  the 
interest  expense. 

The  "Accrued"  Account. — To  distribute  properly  such  ex- 
penses over  the  periods  to  which  they  are  incident  we  must  have 
recourse  to  a  device  known  as  the  "accrued"  account.  In  the 
instance  cited  above  the  interest  incident  to  each  month  is 
one-twelfth  of  $300,  or  $25.  Before  making  the  closing  journal 
entries  an  adjustment  entry  should  be  made  in  the  General 
Journal  to  show  the  expense  incurred  in  form  of  interest  and  the 
corresponding  liability  arising  therefrom,  thus: 

Interest $25.00 

To  Interest  Accrued $25 .  00 

When  this  is  posted  to  the  Ledger,  "interest"  is  charged  with 
the  month's  due  proportion  of  this  expense;  and  "interest  ac- 
crued," which  is  a  real  account,  records  the  concern's  liability 
incurred  on  interest  but  as  yet  not  payable  because  not  due  until 
June  30.  Since  "interest"  is  a  nominal  account,  it  is  closed  into 
profit  and  loss  and  does  not  appear  in  the  balance  sheet.  "In- 
terest accrued,"  being  a  real  account,  appears  in  the  balance 
sheet  as  a  liability. 

At  the  end  of  February  another  entry  is  made  in  the  Journal 


THE  THEORY  OP  ACCRUALS  61 

identical  with  the  one  shown  above.  "  Interest "  is  again  charged 
to  profit  and  loss  and  the  "interest  accrued"  account  shows  a 
liability  for  two  months'  interest,  or  $50.  This  process  is  con- 
tinued until  the  half  year  has  passed  and  interest  for  that  time 
falls  due  and  is  paid.  The  sixth  month's  interest  may  or  may 
not  be  credited  to  "interest  accrued."  If  it  is  credited  to  "in- 
terest accrued"  through  a  journal  entry,  then  when  the  interest 
is  paid  the  following  entry  is  required  in  the  Cash  Journal  (here 
written  in  general  journal  form) : 

Interest  Accrued $150 .  00 

To  Cash $150.00 

If  the  sixth  month's  interest  is  not  credited  to  "interest  accrued," 
then  the  entry  in  the  Cash  Journal  is: 

Interest $  25.00 

Interest  Accrued 125 .  00 

To  Cash $150  00 

Whichever  method  is  followed,  the  result  is  the  same.  If  the 
first  plan  is  pursued  "interest"  for  the  last  month  is  charged 
in  the  General  Journal.  If  the  second  plan  is  followed  "inter- 
est" is  charged  in  the  Cash  Journal  for  the  sixth  month.  In 
either  case  "interest  accrued"  is  closed  out  by  being  charged 
from  the  Cash  Journal  with  the  full  amount  of  the  items  which 
have  accumulated  to  its  credit  during  the  preceding  months.  If 
the  last  month's  interest  is  charged  in  the  Journal  and  credited 
to  "interest  accrued,"  then  when  the  "interest  accrued"  account 
is  finally  closed  by  being  charged  with  the  cash  paid  out,  it 
appears  thus: 

Interest  Accrued 

June  30     To  Cash $150.00    Jan.  31      By  Interest $25.00 

Feb.  28     By  Interest 25.00 

Mar.  31      By  Interest 25.00 

Apr.  30     By  Interest 25.00 

May  31     By  Interest 25.00 

June  30     By  Interest 25.00 

$150.00  $150.00 

If,  on  the  other  hand,  the  sixth  month's  interest  is  charged  in 
the  Cash  Journal,  the  "interest  accrued"  account,  when  finally 
closed,  shows  total  credits,  "by  interest,"  of  $125,  and  a  charge 
"to  cash"  for  the  same  amount.  Through  this  procedure  the 
profit   and   loss   account   for  each  month  is  debited  with  its 


62  ACCOUNTS  IN  THEORY  AND  PRACTICE 

proper  proportion  of  interest  expense  and  the  balance  sheet  as 
at  the  close  of  each  month  shows  what  the  liability  on  interest 
accrued  but  not  due  is.  If  there  is  more  than  one  Uability  upon 
which  interest  is  incurred,  the  same  principle  applies  to  all.  The 
interest  accrued  upon  them  may  be  kept  in  separate  ledger  ac- 
counts and  be  shown  as  separate  liabilities  in  the  balance  sheet, 
or  it  may  be  entered  in  one  interest  accrued  account  and  shown 
as  one  item  in  the  balance  sheet. 

Wages  and  Salaries. — Wages  and  salaries  sometimes  require 
the  same  treatment  as  interest.  Salaries  are  customarily  paid 
monthly,  and  consequently  they  may  be  charged  to  a  "salaries 
expense"  account  when  they  are  paid  in  cash.  By  so  doing  the 
month's  proper  burden  of  this  expense  is  charged  to  profit  and 
loss.  It  is  only  when  the  time  of  payment  of  salaries  is  not 
monthly  that  the  theory  of  accruals  applies.  Wages  are  usually 
paid  weekly  or  semi-monthly,  and  since  the  month-ends  do  not, 
as  a  rule,  correspond  with  week-ends,  there  occurs  an  overlapping 
of  wages  expense  in  a  weekly  or  semi-monthly  period  which 
extend  from  one  month  into  the  next  one.  The  wages  expense 
for  such  a  period  must  be  accurately  pro-rated  over  the  months 
to  which  they  apply. 

Wages  Accrued  Illustrated. — One  illustration  will  suffice.  A 
merchant  pays  his  assistants  semi-monthly.  A  certain  payday 
falls  on  the  seventh  of  June.  The  profit  and  loss  account  for 
May  must  be  charged  with  the  wages  accruing  during  the  last 
week  of  May  even  though  they  are  not  due  until  June  7.  If 
one  week's  wages  amount  to  $40  the  adjustment  can  be  made  in 
the  General  Journal,  thus: 

May  31 

Wages  Expense ^ $40.00 

To  Wages  Accrued $40 .  00 

"Wages  expense"  is  carried  to  the  profit  and  loss  account  and 
"wages  accrued"  enters  the  balance  sheet  as  of  May  31  as  a 
liabihty.  This  "wages  accrued"  account  will  be  closed  when 
wages  are  paid,  June  7,  as  follows  (Cash  Journal) : 

Wages $40.00 

Wages  Accrued 40 .  00 

To  Cash $80.00 

Miscellaneous  Accruals. — The  same  principle  applies  to  all 
other  expenses  which  accrue  over  an  accounting  period,  but  for 


THE  THEORY  OF  ACCRUALS  63 

which  payment  is  delayed  to  a  day  in  some  succeeding  period 
for  some  reason.  Taxes  are  usually  of  this  character.  Theo- 
retically some  very  small  expenses  ought  to  be  similarly  distrib- 
uted. But  the  error  may  be  so  slight  in  charging  them  entirely 
to  profit  and  loss  in  the  month  in  which  they  occur  that  the  work 
required  to  make  a  distribution  is  not  worth  while.  Associa- 
tion dues  of  small  amount  and  similar  items  may  be  thus  cared 
for. 

Deferred  Charges. — As  some  expenses  cannot  be  paid  until 
after  the  period  to  which  they  are  incident  is  closed,  so  other 
expenses  must  be  paid  in  advance  of  the  period  to  which  they 
are  incident.  Perhaps  the  most  important  class  of  such  expenses 
are  those  incurred  by  a  new  enterprise.  When  a  concern  is  in 
this  stage  of  its  development  it  is  frequently  compelled  to  spend 
large  amounts  of  money  on  advertising,  exploiting,  and  general 
development  work,  of  which  the  benefits  are  likely  to  continue 
for  several  years  to  come.  Take  an  iron  mine.  Before  the  ores 
can  be  worked  it  is  necessary  to  strip  the  ore  beds  of  the  over- 
lying strata.  To  charge  the  cost  of  ore-stripping,  calculated  to 
suffice  for,  say,  five  years,  to  profit  and  loss  during  one  year 
would  unjustly  burden  it  with  expenses  really  applicable  to  a 
period  of  five  years.  It  is  better  to  charge  such  unusual  expenses 
to  "deferred  charges,"  or  ''deferred  assets,"  or  "deferred  charges 
to  profit  and  loss,"  these  phrases  being  usied  synonymously. 
Then  at  the  end  of  each  accounting  period  this  account  is  credited 
with  the  amount  applicable  to  that  period  and  a  corresponding 
charge  is  made  to  profit  and  loss. 

Deferred  Charges  Illustrated. — George  Warren  invests 
$100,000  cash  in  a  mine  which  he  is  about  to  develop.  He  pays 
$50,000  for  the  land  which  the  mineral  deposits  underly  and 
invests  $25,000  in  plant  and  machinery.  His  condition  before 
beginning  operations  is  shown  by  the  following  balance  sheet: 

Balance  Sheet,  George  Warren 

Land $  50,000     Capital— George  Warren. .   $100,000 

Plant  and  Machinery 25,000 

Cash 25,000 

$100,000  $100,000 

He  now  spends  $14,400  in  stripping  the  ores  of  overlying  strata, 
thus  uncovering  enough  ore  bed  to  last  for  a  period  of  six  years. 
His  balance  sheet  becomes: 


64  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Balance  Sheet,  George  Warren 

Land $  50,000     Capital— George  Warren. .  $100,000 

Plant  and  Machinery 25,000 

Cash 10,600 

Deferred  Charges 14,400 

$100,000  $100.000 

During  the  first  year  one-sixth  of  the  amount  originally  debited 
to  "deferred  charges"  should  be  written  off  by  monthy  entries 
as  follows : 

Profit  and  Loss $200.00 

To  Deferred  Charges $200.00 

In  this  way  the  monthly  profit  and  loss  account  is  charged  with 
its  proper  proportion  of  the  cost  of  ore-stripping,  and  at  the  end 
of  the  sixth  year  the  entire  amount  of  the  cost  of  stripping,  $14,400, 
will  be  charged  off. 

Wider  Application  of  Theory  of  Deferred  Charges. — In  a 
broader  sense  the  theory  of  deferred  charges  applies  to  all  assets 
which  diminish  in  value  as  time  passes.  These  comprise  build- 
ings, machinery,  tools,  furniture  and  fixtures — in  short,  nearly 
all  classes  of  so-called  fixed  assets,  land  usually  being  an  excep- 
tion to  this  rule.  Investments  in  such  assets  are  in  reality 
expenses  of  future  production,  and  it  is  quite  as  essential  to  accu- 
rate accounting  that  proper  allowance  be  made  in  the  profit  and 
loss  account  for  costs  occasioned  by  the  depreciation  of  the  more 
permanent  assets  as  it  is  to  take  into  consideration  those  ex- 
penses which  are  paid  for  a  shorter  time  in  advance,  as  well  as 
those  which  are  paid  for  during  the  accounting  period  to  which 
they  are  incident.  It  is  best  to  consider  depreciation  as  a 
distinct  topic  since  the  accounting  procedure  required  is  some- 
what different. 


CHAPTER  X 

ACCRUALS  AND  DEFERRED  CHARGES— PRACTICE 

Problem  1. — A  merchant,  Oliver  Matthews,  mortgages  his 
store  and  lot  in  order  to  secure  funds  with  which  to  make  certain 
improvements.  The  transaction  by  which  the  money  is  secured 
occurs  on  June  12,  1920,  the  following  being  the  entry  in  the 
merchant's  Cash  Journal  put  in  form  of  a  General  Journal  entry: 

June  12,  1920 

Cash $4,000,00 

Mortgage $4,000. 00 

For  loan  secured  by  mortgage,  interest  at  6 
per  cent.  ,  payable  semi-annually. 

Mr.  Matthews  employs  help  which  he  pays  at  the  end  of  each 
two  weeks'  period.  The  last  pay  day  occurred  June  19  and  the 
one  preceding  that  on  June  5.  The  next  one  will  occur  on  July 
3  for  2  weeks  to  and  including  July  3.  The  amount  of  wages 
at  each  pay  day  is  $327.32,  The  disbursement  on  June  5  was 
charged  thus: 

Wages  Accrued $210.42 

Wages 116.90 

Cash $327.32 

For  payment  of  accrued  wages,  2  weeks. 

Mr.  Matthews'  annual  salary  is  $2,400  which  he  draws  quart- 
erly, Jan.  31,  April  31,  July  31,  and  so  on  for  the  preceding 
quarter. 

Mr.  Matthews  has  engaged  in  an  extensive  advertising  cam- 
paign during  the  preceding  months  of  the  present  calendar  year, 
the  disbursements  on  that  account  amounting  to  the  following 
sums: 

January $300.00 

February 216.00 

March 300.00 

April 348.00 

May 192.00 

June 324.00 

5  6o 


66  ACCOUNTS  IN  THEORY  AND  PRACTICE 

It  is  calculated  that  the  amount  expended  thus  each  month 
represents  a  deferred  charge  which  may  be  equitably  charged  to 
profit  and  loss  over  a  period  of  12  months.  Thus  of  the  $300 
spent  in  January,  ^{2,  or  $25,  is  a  proper  charge  to  expense  in 
January,  3^12  in  March,  and  so  on. 

The  trial  balance  of  the  Ledger  taken  on  June  30  is  as  follows: 

Trial  Balance,  Oliver  Matthews,  as  at  June  30,  1920 : 

Oliver  Matthews— Capital $25,000. 00 

Store  and  Lot $16,000. 00 

Furniture  and  Fixtures 840.00 

Delivery  Equipment. ." 900. 00 

Inventory,  May  31 10,181 .  00 

Merchandise 2,000.00 

Accounts  Receivable 3,400 .  00 

Notes  Receivable 500.00 

Supplies 300.00 

Wages 444.22 

Salaries  Accrued — OLver  Matthews 400. 00 

Expense 620.00 

Cash 800.00 

Mortgage 4,000.00 

Accounts  Payable. 2,320. 12 

Notes  Payable 200. 00 

Discount  on  Purchases 65 .  10 


$33,985.22    $33,985.22 


The  inventory  on  June  30  is  $9,940.00.  After  making  such 
Journal  entries  as  are  necessary  to  adjust  the  interest  accrued  on 
mortgage,  wages  accrued,  and  salaries  accrued,  draw  up  a 
trial  balance  showing  these  adjustments. 

These  adjustment  entries  should  be  in  the  following  form: 

Interest 

Interest  Accrued 

To  bring  into  the  books  the  expense  of  interest 
accrued  to  date  on  mortgage  and  to  show  the 
liability  therefor. 

Wages 

Wages  Accrued 

To  bring  into  the  books  the  expense  of  wages  accrued 
to  date  and  to  show  the  liability  therefor. 

Salaries 

Salaries  Accrued 

To  bring  into  the  books  the  expense  of  salaries 
accrued  to  date  and  to  show  the  liability  therefor. 


ACCHUALS  AND  DEFERRED  CHARGES  67 

In  finding  interest  accrued  reckon  it  on  $4,000  for  18  days 
{%  of  1  mo.),  and  for  wages  accrued  reckon  11  days. 

Sometimes  all  adjustments  are  made  before  taking  the  trial 
balance.  Here,  however,  it  becomes  necessary  to  draw  up  a 
second  trial  balance.  The  footings  of  this  trial  balance  should 
be  $34,454.40. 

The  accounts,  "Interest  Accrued,"  "Wages  Accrued,"  and 
"Salaries  Accrued"  are  real  accounts  while  the  corresponding 
debit  accounts,  "Interest,"  "Wages"  and  "  Salaries  "are  nominal. 
When  these  do  not  appear  in  the  trial  balance  submitted  they 
must  be  supplied  in  the  trial  balance  drawn  up  to  show  effects 
of  adjustments.  From  the  revised  trial  balance  and  other  in- 
formation presented  set  up  the  closing  Journal  entries  and  present 
a  profit  and  loss  statement  and  a  balance  sheet. 

Problem  2. — A.  G.  Williams  is  a  merchant  engaged  in  the  retail 
business.  Before  making  adjustments  for  certain  accruals  and 
deferred  charges  he  takes  a  trial  balance  as  at  Dec.  31,  1919, 
which  is  as  follows: 

Trial  Balance,  A.  G.  Williams,  as  at  Dec.  31,  1919 : 

A.  G.  Williams— Capital $  50,000.00 

Real  Estate $  25,000.00 

Delivery  Equipment 2,500. 00 

Inventory,  June  30,  1919 30,000.00 

Furniture  and  Fixtures 3,000.00 

Purchases 57,300.00 

Sales 63,350.00 

Accounts  Receivable 4,520.00 

Wages 1,900.00 

Supplies  on  Hand,  June  30,  1919 620.00 

Supplies  Purchased 300.00 

Interest 350 .  00 

Salaries 1,500 .  00 

Miscellaneous  Expense 420. 00 

Cash 2,000.00 

Notes  Payable 10,000.00 

Accounts  Payable -  5,960.00 

Rent  of  Delivery  Equipment 100.00 


$129,410.00    $129,410.00 


Wages  were  last  paid  on  Dec.  27,  so  that  4  days*  wages  accrued 
are  not  shown.  These  amount  to  $127.50.  Interest  on  Notes 
Payable  is  paid  semi-annually  March  1,  and  Sept.  1,  respectively, 


68  ACCOUNTS  IN  THEORY  AND  PRACTICE 

at  the  rate  of  6  %  per  annum.  Salaries,  totaling  $3,000.00, 
are  paid  to  the  proprietor  quarterly.  Mar.  31,  June  30,  Sept.  30, 
and  Dec.  31.  There  are  on  hand  supplies  valued  at  $500.00. 
After  making  all  necessary  adjustments  set  up  a  revised  trial 
balance,  entries  to  close,  and  a  profit  and  loss  account  and  balance 
sheet. 


CHAPTER  XI 

DEPRECIATION,  BAD  DEBTS,  AND  VALUATION 
RESERVES 

Nearly  every  business  enterprise  incurs  unavoidable  expenses 
due  to  the  deterioration  of  material  assets  and  the  uncollectible 
character  of  some  of  its  accounts  receivable.  These  two  classes 
of  losses,  although  in  no  way  related  to  each  other,  can  best  be 
considered  together  because  of  the  similarity  in  the  accounting 
methods  required  to  record  and  interpret  them. 

Meaning  of  Depreciation. — In  a  wide  sense,  depreciation 
losses  include  bad  debts.  But  for  practical  purposes  it  is  better 
to  limit  the  application  of  the  word  to  the  deterioration  of  physical 
assets.  Even  when  the  application  of  the  word  is  thus  limited 
it  has  three  distinct  uses  which  may  be  discussed  under  the  three- 
fold terminology  of 

1.  Wear  and  tear 

2.  Inadequacy 

3.  Obsolescence 

Nature  of  Depreciation. — Depreciation  from  wear  and  tear 
occurs  when  a  material  structure  undergoes  physical  deterioration 
due  to  weathering  or  usage,  or  both.  Depreciation  from  inade- 
quacy occurs  when  a  material  structure  undergoes  deterioration 
in  value,  due  to  its  failure  to  perform  the  functions  which  increasing 
demands  and  changing  conditions  impose  upon  it.  Depreciation 
from  obsolescence  occurs  when  a  material  structure  undergoes 
deterioration  in  value,  due  to  the  invention  of  devices  better 
adapted  to  perform  the  same  work. 

Nature  of  Invested  Capital. — Failure  to  make  adequate 
allowance  for  depreciation  costs  is  a  prolific  source  of  financial 
embarrassment.  This  truth  is  a  corollary  of  a  fundamental 
principle  of  accounts,  viz.,  that  the  original  investment  must  be 
kept  intact.    To  prosper,  a  concern  must  be  supported  by  an 

69 


70  ACCOUNTS  IN  THEORY  AND  PRACTICE 

invested  capital  large  enough  to  meet  the  various  demands 
made  by  the  productive  and  distributive  processes.  Some  of 
these  demands  are  for  fixed  capital,^  i.e.,  capital  invested  in 
buildings,  equipment,  and  so  on.  Other  demands  are  for  working 
capital,  i.e.,  capital  in  the  form  of  cash,  accounts  receivable, 
acceptances  receivable,  merchandise,  and  so  on.  In  a  general 
way  the  fixed  assets  counterbalance  the  fixed  liabilities  while 
working  assets  counterbalance  current  liabilities  and  provide 
the  means  for  temporarily  increasing  the  volume  of  the  trans- 
actions, when  desirable,  and  of  paying  wages  and  liquidating 
other  current  costs. 

Anything  which  diminishes  the  amount  of  the  working  capital 
creates  a  stringency  in  the  funds  available  for  purchasing  com- 
modities and  for  paying  the  usual  running  expenses  as  they  fall 
due.  Such  a  stringency  is  very  quickly  perceived  and  therefore 
usually  remedied  before  it  is  too  late.  The  diminution  of  the 
fixed  capital,  however,  in  the  form  of  depreciation  of  physical 
plant,  is  an  evil  which  may  continue  for  a  much  longer  time 
without  creating  alarm  of  an  apparent  shortage  of  any  kind, 
but  which  for  this  very  reason  is  liable,  ultimately,  to  leave  a  con- 
cern in  a  very  much  depleted  condition.  Only  when  it  becomes 
necessary  to  make  replacements  or  extensive  repairs — which 
must  generally  be  met  by  drawing  heavily  on  working  capital — 
does  a  situation  of  apparent  difficulty  arise.  But  it  may  then 
be  too  late  to  recoup  the  long-accruing  losses  which  have  in- 
sidiously consumed  the  value  of  the  fixed  assets,  at  the  same  time 
retaining  sufficient  funds  to  meet  running  expenses  which  cannot 
be  delayed.  In  such  cases  the  only  recourse  left  is  to  borrow 
money  to  pay  a  part  of  the  expenses,  thus  saddhng  the  enterprise 
with  increased  indebtedness  and  larger  interest  burdens  without 
increasing  its  productive  capacity — a  procedure  which  alleviates 
but  does  not  cure  the  difficulty. 

Efifects  of  Depreciation  Illustrated. — ^Lawrence  Oliver  begins 
business  with  cash,  $200,000,  $190,000  of  which  he  invests  in 
plant,  etc.,  reserving  $10,000  in  cash  for  current  needs.  His 
condition  is  then  as  shown  in  the  following  balance  sheet: 

1  The  word  "capital"  is  here  employed  in  the  economic  sense  as  re- 
ferring to  wealth  employed  to  produce  wealth.  In  this  book  the  word  is 
more  frequently  employed  in  the  accounting  sense  as  indicating  net  worth 
or  proprietorship. 


DEPRECIATION,  BAD  DEBTS,  ETC.  71 

Balance  Sheet,  Lawrence  Oliver 

Land $  20,000     Capital— Lawrence  Oliver.   $200,000 

Buildings 100,000 

Fixtures 30,000 

Inventory 40,000 

Cash 10,000 


$200,000  $200,000 


The  buildings  will  not  last  forever.  They  will  depreciate 
in  value  with  the  passing  of  time.  The  fixtures  also  will  de- 
preciate. Nevertheless  it  will  be  possible  for  Oliver  to  do  business 
for  a  considerable  number  of  years  without  in  any  way  being 
inconvenienced  by  the  depreciation  of  his  assets.  He  makes 
no  allowance  for  this  lessening  of  asset  values.  At  the  end  of 
the  first  year  the  profit  and  loss  account  for  the  year  appears 
thus: 

Profit  and  Loss,  Lawrence  Oliver 

Inventory  (old) $  40,000     Inventory  (new) $  44,000 

Purchases 300,000     Sales 330,000 

Expenses 10,000 

Balance,  Net  Profit 24,000 

$374,000  $374,000 

Proceeding  on  the  assumption  that  he  has  made  a  net  profit 
of  $24,000,  Oliver  withdraws  that  amount  from  the  business,  in 
cash,  and  spends  it  for  private  purposes.  He  continues  doing 
the  same  for  twenty  years,  making  no  allowance  for  depreciation 
of  buildings  and  fixtures  in  the  profit  and  loss  account,  and 
withdrawing  and  spending  as  much  as  the  balance  of  the  profit 
and  loss  account  indicates  to  be  net  profit.  His  balance  sheet  at 
the  end  of  the  twentieth  year  is  as  follows: 

Balance  Sheet,  Lawrence  Oliver 

Land $  20,000     Capital— Lawrence  Oliver.   $200,000 

Buildings 100,000     Accounts  Payable 18,000 

Fixtures 30,000     Acceptances  Payable 10,000 

Inventory 43,000 

Accounts  Receivable 20,000 

Cash 15,000 

$228,000  $228,000 

Oliver  now  discovers  that  his  fixtures  are  practically  worn 


72  ACCOUNTS  IN  THEORY  AND  PRACTICE 

out  and  that  his  buildings  are  becoming  obsolete  and  inadequate 
to  meet  modern  requirements.  A  fair  valuation  shows  the 
fixtures  to  be  worth  $5,000,  and  the  buildings  $25,000.  During 
the  twenty  years  the  fixtures  have  depreciated  $25,000,  or  $1,250 
per  year,  on  an  average.  During  the  same  period  the  buildings 
have  depreciated  $75,000,  or  $3,750  per  year,  on  an  average. 
This  means  that  each  year  of  twenty  Oliver  incurred  a  deprecia- 
tion expense  of  $5,000  which  he  entirely  overlooked,  making  no 
charge  for  it  in  the  profit  and  loss  account,  and  consequently 
spending  each  year  $5,000  of  capital,  thinking  it  to  be  profit. 
As  a  result  he  has  diminished  his  actual  capital  by  exactly  one- 
half,  as  the  following  balance  sheet,  revised  to  show  actual 
values,  indicates: 

Balance  Sheet,  Lawrence  Oliver 

Land $  20,000  Capital— Lawrence  Oliver.   SI 00,000 

Buildings 25,000     Accounts  Payable 18,000 

Fixtures 5,000     Acceptances  Payable 10,000 

Inventory 43,000 

Accounts  Receivable 20,000 

Cash 15.000 


$128,000  $128,000 


This  shows  a  serious  condition  of  affairs,  yet  one  which  has 
many  analogies  in  real  life.  Oliver,  by  spending  more  than  he 
makes,  because  of  erroneous  accounting,  has  greatly  depleted 
his  net  worth.  Buildings  and  fixtures  must  soon  be  replaced. 
Where  are  the  replacement  funds  to  be  secured?  For  this  pur- 
pose $100,000  will  be  required.  There  is  $15,000  cash  on  hand, 
and  the  accounts  receivable,  if  all  are  collectible,  will  bring  in  an 
additional  $20,000.  But  most  of  this  cash  will  be  needed  to 
liquidate  the  acceptances  and  accounts  payable  as  they  mature. 
Together  these  amount  to  $28,000,  which  leaves  only  $7,000  in 
cash  free  for  other  purposes.  Oliver  must  get  the  money  out- 
side the  business.  Unless  he  can  fall  back  on  his  own  private 
fortune,  he  must  borrow. 

Assume  that  Oliver  borrows  the  required  amount,  $100,000, 
at  6  per  cent  interest,  by  giving  a  mortgage  on  all  real  estate 
including  the  newly  constructed  buildings.  The  old  buildings 
and  fixtures  are  disposed  of  for  $30,000,  cash.  This  with  the 
$100,000  borrowed  furnishes  the  amount  required  to  pay  for  the 


DEPRECIATION,  BAD  DEBTS,  ETC.  73 

new  buildings.  If  other  accounts  than  those  directly  affected 
by  the  sale  of  the  old  fixtures  and  buildings  and  the  construction 
and  purchase  of  the  new  ones  remain  unchanged,  the  balance 
sheet  becomes: 

Balance  Sheet,  Lawrence  Oliver 

Land $  20,000     Capital— Lawrence  Oliver.   $100,000 

Buildings 100.000     Mortgage 100,000 

Fixtures 30,000     Accounts  Payable 18,000 

Inventory 43,000     Acceptances  Payable 10,000 

Accounts  Receivable 20,000 

Cash 15,000 


$228,000  $228,000 


As  a  consequence  of  erroneous  accounting,  Oliver  has  reduced 
his  interest  in  the  business  to  one-half  its  original  amount.  He 
has,  for  all  purposes,  shared  it  half  and  half  with  the  mortgagee 
who  loaned  him  $100,000.  Interest  on  the  mortgage  amounts 
to  $6,000  per  annum,  which  is  an  addition  to  the  fixed  charges 
or  expenses  of  the  business.  If  Oliver  continues  for  another 
twenty  years  in  the  same  manner  as  during  the  past  twenty  years, 
his  net  worth  will  be  reduced  to  nothing  and  the  creditors  will 
become  the  owners  of  the  enterprise. 

Depreciation  a  Cause  of  Bankruptcy. — Although,  in  actual 
business,  conditions  do  not  recur  with  unchanging  regularity, 
the  situation  described  above  has  many  prototypes.  Their 
similarity  to  our  illustration  is  sometimes  obscured  by  the 
multiplicity  of  detail  surrounding  them.  The  failure  to  under- 
stand the  true  nature  of  depreciation,  namely,  that  it  is  an 
expense,  is  a  prolific  source  of  financial  embarrassment  and  bank- 
ruptcy. Sometimes  the  failure  to  make  slifficient  allowance 
for  depreciation  is  willful,  being  a  recourse  to  show  favorable 
profits  when  they  are  not  favorable  in  reality.  Many  expenses, 
such  as  labor,  interest,  and  taxes,  must  be  paid  within  a  short 
period  after  they  are  incurred.  Therefore  it  is  natural  that 
depreciation  be  sometimes  neglected  in  the  presence  of  more 
pressing  claims — only  too  frequently  with  the  result  that  in  the 
end  it  presents  a  problem  much  more  serious  than  those  whose 
solution  was  aided  by  ignoring  it. 

Valuation  Reserves. — Depreciation  expense  or  burden  may  be 
distributed  equitably  by  a  simple  accounting  procedure.  It 
makes  use  of  "valuation  reserves."     Suppose  that  Oliver  had 


74  ACCOUNTS  IN  THEORY  AND  PRACTICE 

determined  to  make  due  allowance  for  depreciation  instead  of  ne- 
glecting it.  This  he  could  have  done  by  making  the  following 
entry  in  the  General  Journal : 

Profit  and  Loss $5,000.00 

To  Reserve  for  Depreciation  of  Fixtures $1,250.00 

Reserve  for  Depreciation  of  Building 3,750.00 

To  charge  profit  and  loss  for  the  amount  of 
depreciation   expense   for   the   year  ending 


The  reserves  credited  in  this  entry  are  termed  valuation 
reserves.  They  perform  an  important  and  unique  function. 
Accounts  are  opened  in  the  Ledger  entitled  "Reserve  for  Deprecia- 
tion of  Fixtures"  and  "Reserve  for  Depreciation  of  Building." 
When  the  above  entry  is  posted  these  reserve  accounts  will  be 
credited  with  the  amounts  indicated.  These  reserves  are  real 
accounts  and  remain  open  in  the  Ledger.  Although  they  have 
credit  balances  they  represent  neither  liabilities  nor  capital, 
as  do  most  real  accounts  having  credit  balances.  They  are  in  a 
distinct  class,  because  their  usefulness  arises  out  of  the  comple- 
mentary relationship  which  exists  between  them  and  the  asset 
accounts,  "Fixtures"  and  "Buildings."  They  evaluate,  i.e., 
give  a  valuation  to,  fixtures  and  buildings.  They  record  the 
accrued  depreciation  on  these  assets.  The  present  value  of 
fixtures  and  buildings  cannot  be  found  from  an  examination  of 
the  fixtures  and  buildings  accounts  because  these  accounts  stand 
charged  with  the  original  cost  of  these  assets.  It  is  quite  es- 
sential to  keep  this  original  cost  figure  unchanged.  This  in 
itself  justifies  the  use  of  complementary  valuation  reserves. 
Otherwise  accounting  requirements  would  be  satisfied  by  sub- 
stituting for  the  above  entry  the  following: 

Profit  and  Loss $5,000.00 

To  Buildings $3,750.00 

Fixtures 1,250.00 

So  far  as  the  profit  and  loss  account  is  concerned  this  entry 
has  the  same  effect  as  the  preceding.  But  it  leaves  the  asset 
accounts  in  the  Ledger  in  a  different  condition.  Instead  of 
permitting  "Buildings"  and  "Fixtures"  to  remain  charged  with 
$100,000  and  $30,000,  respectively,  and  creating  depreciation 
reserve  accounts  for  both  with  credit  balances  of  $3,750  and 


DEPRECIATION,  BAD  DEBTS,  ETC. 


75 


$1,250,  respectively,  it  diminishes  the  "Buildings"  and  "Fix- 
tures" accounts  by  these  amounts.  Technically,  either  method 
is  correct.  But  when  the  depreciation  allowance  is  credited 
directly  to  the  asset  account  to  which  it  applies,  the  balances  of 
those  accounts  no  longer  show  original  cost.  A  thorough  com- 
prehension of  the  advantages  of  opening  valuation  reserve 
accounts  will  be  secured  as  we  proceed. 

Valuation  Reserves  Illustrated. — If,  each  month,  Oliver  had 
charged  profit  and  loss  and  credited  the  proper  valuation  reserve 
accounts  to  cover  the  depreciation  of  buildings  and  fixtures,  his 
balance  sheet  at  the  end  of  the  twentieth  year  would  have  been 
essentially  as  follows : 

Balance  Sheet,  Lawrence  Oliver 


Land $  20,000 

Buildings •.  100,000 

Fixtures 30,000 

Inventory 43,000 

Accounts  Receivable 20,000 

Cash 115,000 


Capital— Lawrence  Oliver.  $200,000 
Reserve  for  Depreciation  of 

Buildings 75,000 

Reserve  for  Depreciation  of 

Fixtures 25,000 

Accounts  Payable 18,000 

Acceptances  Payable 10,000 


$328,000 


$328,000 


This  balance  sheet  shows  assets  $100,000  in  excess  of  those 
shown  in  the  balance  sheet  on  page  73.  The  buildings  and 
fixtures  are  not  worth  the  amount  shown,  but  $25,000  and  $5,000, 
respectively.  To  show  the  condition  even  better  it  is  proper 
to  show  the  depreciation  reserves  deducted  from  their  comple- 
mentary asset  accounts,  as  below: 

Balance  Sheet,  Lawrence  Oliver 

Land $  20,000     Capital— Lawrence  Oliver.  $200,000 

Buildings $100,000 

Less:  Reserve  for 

Depreciation..       75,000      25,000     Accounts  Payable 18,000 

Fixtures $30,000 

Less:  Reserve  for 

Depreciation . .       25,000         5,000     Acceptances  Payable 10,000 

Inventory 43,000 

Accounts  Receivable 20,000 

Cash 115,000 

$228,000  $228,000 


76  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Employment  of  Reserves. — By  charging  the  profit  and  loss 
account  each  year  with  the  amount  of  the  depreciation,  $5,000, 
"paper"  profits  are  diminished  by  that  amount.  Consequently 
Oliver  would  withdraw  that  much  less  cash  from  the  business,  a 
sum  which  in  twenty  years  would  amount  to  $100,000.  In  the 
balance  sheet  given  above  this  is  shown  as  an  addition  to  cash. 
It  is  not  necessary,  however,  that  the  amount  thus  reserved  be 
kept  in  the  form  of  cash.  The  essential  step  is  to  keep  it.  Or- 
dinarily it  can  best  be  employed  in  the  usual  channels  of  business 
as  a  part  of  working  or  fixed  capital,  or  both.  When  the  time 
comes  to  make  the  replacement  of  the  buildings  and  fixtures, 
this  wealth  will  be  found  "on  duty,"  either  in  the  form  of  cash 
or  of  wealth  which  will  serve  as  security  in  obtaining  a  loan  of 
cash.  Even  if  cash  is  borrowed  the  proprietor's  net  worth  is  not 
diminished.  He  still  possesses  his  original  capital  and  any 
money  he  may  borrow  will  be  to  increase  the  amount  invested 
in  the  business,  not  to  take  the  place  of  funds  improperly  with- 
drawn under  the  guise  of  profits. 

Growth  of  Depreciation  Reserves. — The  depreciation  reserve 
grows  at  a  rate  which  presumably  corresponds  with  the  rate  of 
decrease  in  the  value  of  the  corresponding  asset.  It  is  quite 
improbable,  of  course,  that  the  amount  of  the  depreciation 
reserve  at  the  end  of  any  accounting  period  will  exactly  equal 
the  decrease  in  value  of  the  corresponding  asset.  An  approxi- 
mation is  the  best  that  can  be  expected.  Estimates  of  the 
lifetime  of  buildings  may  require  revision  from  time  to  time. 
Unexpected  changes,  inventions,  etc.,  may  cut  down  the  use- 
fulness of  a  machine  very  greatly,  causing  it  to  be  scrapped  long 
before  it  is  worn  out.  Continuation  in  use  of  inadequate  or 
obsolete  machinery  may  become  a  positive  source  of  loss,  making 
earlj'  replacement  almost  compulsory.^  Various  disturbing 
elements  enter  which  make  the  depreciation  problem  one  of  the 
most  difficult  with  which  the  accountant  is  confronted. 

The  Reserve  as  a  Clearing  Account. — One  additional  function 
of  the  depreciation  reserve  requires  discussion  here.  This  is  its 
use  as  a  clearing  account  when  replacements  are  made.  We  have 
seen  that  the  asset  accounts  remain  charged  with  the  original 
cost  price,  while  the  depreciation  is  shown  in  the  credit  balance 
of  •  the   depreciation  reserve   account.     It  follows  that  if  the 

'  See  Saliers:  Principles  of  Depreciation,  p.  30. 


DEPRECIATION,  BAD  DEBTS,  ETC.  77 

reserve  account  reflects  accurately  the  amount  of  the  deprecia- 
tion, it  will  be  equal  to  the  amount  charged  (original  cost)  to 
the  asset  account,  when  the  asset  is  entirely  worn  out  or  useless. 
Or  if  the  asset  possesses  a  scrap  value  or  possibly  a  second  hand 
value,  then  theoretically  the  depreciation  reserve  should  equal 
the  amount  represented  by  the  difference  between  original  cost 
and  scrap  or  second  hand  value.  Thus  if  a  merchant  begins 
business  with  affairs  as  shown  in  the  following  balance  sheet, 

Balance  Sheet 

Buildings $20,000     Capital $30,000 

Other  Assets 10,000 


$30,000  $30,000 


and  his  buildings,  during  a  period  of  forty  years,  depreciate  in 
value  to  zero,  his  balance  sheet  will  then  show. 

Balance  Sheet 

Buildings $20,000  Capital $30,000 

Less:  Reserve  for 

Depreciation. . .     20,000 


Other  Assets $30,000 


$30,000  $30,000 


assuming  that  there  have  been  no  changes  except  in  the  valua- 
tion account  which  indicates  the  amount  reserved  to  take  the 
place  of  the  decreased  value  of  buildings,  and  in  the  asset  ac- 
counts which  contain  this  reservation.  When  the  time  arrives 
to  make  the  replacement  of  the  buildings  the  old  building  ac- 
count is  closed  by  charging  it  to  the  depreciation  reserve  account 
through  the  following  journal  entry: 

Reserve  for  Depreciation $20,000.00 

To  Buildings $20,000.00 

after  which  the  balance  sheet  becomes: 

Balance  Sheet 
Other  Assets $30,000     Capital $30,000 


$30,000  $30,000 

and  after  the  replacement  is  made: 

Balance  Sheet 

Buildings $20,000     Capital $30,000 

Other  Assets 10,000 

$30,000  $30,000 


78  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Average  Normal  Depreciation. — In  practice  it  is  customary  to 
set  up  a  single  depreciation  reserve  to  cover  a  number  of  assets 
having  varying  terms  of  longevity.  In  this  case  the  reserve 
never  entirely  disappears  from  the  balance  sheet,  but  at  the  end 
of  any  accounting  period  its  amount  reflects,  theoretically,  the 
total  accrued  depreciation  of  existing  assets.  When  buildings, 
etc.,  are  new,  the  reserve  grows  rapidly  in  amount,  but  as  replace- 
ments begin  to  be  made  and  the  original  cost  of  assets  replaced  is 
charged  to  it,  its  growth  becomes  less  rapid.  Finally,  when  the 
plant  arrives  at  a  normal  condition  replacements,  on  an  average 
from  year  to  year,  equal  depreciation,  and  the  reserve  tends  to 
remain  stationary.  Its  average  credit  balance  then  indicates 
the  extent  to  which  depreciation  unavoidably  exists  among  the 
assets,  owing  to  the  fact  that  there  are  always  some  assets  which 
are  in  a  condition  of  greater  or  less  depreciation.  When  a  plant 
arrives  at  that  stage  where  the  depreciation  reserve  remains 
about  the  same  year  after  year,  it  may  be  said  to  have  reached  a 
state  of  average  normal  depreciation. 

Efficiency  vs.  Depreciation. — This  does  not  necessarily  mean 
that  the  efficiency  and  earning  power  of  the  assets  are  impaired. 
On  the  contrary  they  are  likely  to  be  greater  than  when  the 
plant  was  new.  Nor  does  it  mean  that  the  total  value  of  the 
assets  is  any  less  than  when  the  plant  was  new,  for  it  is  not. 
It  simply  means  that  the  value  of  certain  of  the  assets  is  less 
because  a  portion  of  their  useful  lifetime  has  expired,  and  that 
whatever  has  been  lost  in  this  way  has  been  compensated  for  by 
reservations  in  some  other  form  of  assets — possibly  by  an  in- 
crease in  the  cash  account,  or  more  likely  by  an  enhancement  in 
value  of  some  of  the  fixed  assets  or  the  purchase  of  additional 
ones. 

Bad  Debts  Losses  an  Estimate. — The  accounting  procedure 
employed  to  care  for  depreciation  may  be  used  to  care  for  losses 
in  the  form  of  uncollectible  accounts  receivable.  The  amount  of 
the  loss  arising  from  this  source  depends  upon  the  character  of 
the  business  and  the  diligence  employed  in  selecting  customers 
and  in  collecting  outstanding  accounts.  The  amount  of  the  loss 
from  this  source  sustained  during  any  particular  accounting 
period  is  necessarily  a  matter  of  estimate,  because  at  least  a  part 
of  the  accounts  receivable  originating  during  such  period  cannot 
be  liquidated  within  the  period.  It  is  customary  to  make  this 
estimate  upon  the  basis  of  past  losses,  and  by  a  journal  entry  to 


DEPRECIATION,  BAD  DEBTS,  ETC.  79 

charge  the  amounts  thus  estimated  to  profit  and  loss,  at  the  same 
time  crediting  a  reserve  for  bad  debts  thus : 

Profit  and  Loss 

To  Reserve  for  Bad  Debts 

To  charge  profit  and  loss  and  credit  reserve 
for  bad  debts  for  the  estimated  loss  on 
uncollectible  accounts  for  the  period 
ending . 

Accounting  for  Actual  Losses. — When  an  individual  account 
receivable  is  found  to  be  worthless  it  is  charged  to  the  reserve 
for  bad  debts,  thus: 

Reserve  for  Bad  Debts 

To  Accounts  Receivable  (name  of  Party) 

Below  is  the  balance  sheet  of  a  merchant  after  the  reserve 
for  bad  debts  for  his  estimated  losses  on  uncollectible  accounts 
is  set  up: 

Balance  Sheet 

Accounts  Receivable $100,000     Capital $399,500 

Less:     Reserve     for     Bad 

Debts 500 

$  99,500 
Other  Assets $300,000 

$399,500  $399,500 

During  the  next  accounting  period  all  accounts  receivable  which 
originated  during  the  preceding  period  are  collected,  with  the 
exception  of  the  following,  which  are  found  to  be  worthless: 

The  Imperial  Company $200. 00 

Arthur  Morris 233.60 

Harper  and  Jones 23. 10 

Total $456. 70 

The  following  journal  entries  are  in  order  at  the  time  each  ac- 
count, respectively,  is  found  worthless: 

Reserve  for  Bad  Debts $200.00 

To  the  Imperial  Company $200.00 

Reserve  for  Bad  Debts 233.60 

To  Arthur  Morris 233.60 

Reserve  for  Bad  Debts 23. 10 

To  Harper  and  Jones 23 ,  10 


80  ACCOUNTS  IN  THEORY  AND  PRACTICE 

These  entries  close  the  worthless  accounts  receivable  and 
reduce  the  reserve  for  bad  debts  to  a  credit  balance  of  $43.40, 
This  amount  measures  the  excess  of  the  allowance  made  for 
bad  debts  over  the  actual  loss  from  that  source.  The  allowance 
for  the  next  period  might  therefore  be  somewhat  smaller. 
Enough  should  be  charged  to  profit  and  loss  and  credited  to  the 
reserve  for  bad  debts,  each  period,  to  equal,  on  an  average,  the 
loss  from  that  source.  If  the  reserve  gradually  grows  larger  it 
is  an  indication  that  an  excessive  allowance  is  being  made — more 
than  is  necessary  to  cover  losses. 


CHAPTER  XII 

DEPRECIATION,  BAD  DEBTS,  AND  VALUATION 
RESERVES— PRACTICE 

Problem  1. — Following  is  the  trial  balance  of  the  Ledger  of 
James  Andrews  as  at  December  31,  1919: 

James  Andrews,  Capital $  40,000.00 

James  Andrews,  Withdrawals $       200. 00 

Delivei-y  Equipment 5,560. 00 

Store  and  Lot 15,000.00 

Furniture  and  Fixtures 600 .  00 

Purchases 60,000. 00 

Sales 60,000.00 

Inventory,  Dec.  31,  1918 10,000.00 

Accounts  Receivable 15,000. 00 

Accounts  Payable 6,000.00 

Cash 3,000.00 

Reserve  for  Depreciation  of  Store  Building 250.00 

Reserve  for  Depreciation  of  Delivery  Equipment  500 .  00 

Reserve    for    Depreciation    of    Furniture    and 

Fixtures 60. 00 

Wages 6,000.00 

Interest 200.00 

General  Expense 700.00 

Advertising 250.00 

Insurance 300.00 


$106,810.00     $106,810.00 

The  following  additional  data  is  given.  The  inventory  as  of 
Dec.  31,  1919,  is  $15,000;  advertising  includes  $100  paid  in 
advance;  while  $200  of  the  insurance  is  prepaid.  The  store 
building  cost  $11,000,  and  has  an  estimated  life  of  40  years  and 
an  estimated  residual  value  of  $1,000.  One  year's  depreciation 
has  already  been  written  off.  The  delivery  equipment  is  written 
down  at  the  rate  of  $500  per  annum  and  the  furniture  and  fixtures 
at  the  yearly  rate  of  10  per  cent  on  cost, 
a  81 


82  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Submit  (a)  adjustment  and  closing  journal  entries,  (6)  a 
profit  and  loss  account,  and  (c)  a  balance  sheet. 

Note. — In  making  entries  for  depreciation,  charge  deprecia- 
tion and  credit  the  proper  depreciation  reserve.  This  deprecia- 
tion account  is  a  nominal  account  and  is  closed  into  profit  and 
loss.  When  this  method  is  pursued  the  entry  charging  deprecia- 
tion and  crediting  the  reserve  is  strictly  an  adjustment  entry  and 
may  be  made  before  taking  a  trial  balance.  Similarly  the  ad- 
justments for  advertising  and  insurance  might  be  made  before 
taking  a  trial  balance.  This,  of  course,  is  impossible  here  because 
the  trial  balance  given  above  was  taken  before  making  the 
adjustments. 

The  capital  account  of  James  Andrews  as  at  Jan.  1,  1920, 
should  be  $46,840.00. 

In  setting  up  the  balance  sheet  show  the  depreciation  reserves 
as  deductions  from  the  asset  accounts  to  which  they  are  supple- 
mentary, thus: 

(a)  (fe) 

Store  and  Lot 

Less:  Depreciation  Reserve 


The  deductions  should  be  made  in  interior  column  (a)  and  the 
net  result  shown  in  column  (6).  Also  classify  the  assets  as 
fixed,  current,  and  deferred,  and  the  liabilities  as  fixed  (if  any), 
current,  and  capital  account. 

The  accounting  period  here  is  one  year.  It  is  customary  to 
close  books  monthly,  however,  and  when  that  is  done  it  is  neces- 
sary to  enter  all  accruals  and  set  up  all  reserves  on  a  monthly 
instead  of  a  yearly  basis.  Even  then,  however,  in  case  of  cor- 
porations, a  yearly  statement  is  necessary  in  order  to  report  to 
the  government  for  income  tax  purposes,  and  in  any  case  to  show 
in  proper  form  the  results  of  the  fiscal  year's  business.  This 
consists  of  a  profit  and  loss  statement  compiled  from  the  monthly 
statements,  and  a  balance  sheet  as  of  the  close  of  the  fiscal  year. 
The  balance  sheet  is  the  same  whether  the  books  are  closed 
monthly  or  not. 

Problem  2. — ^The  following  is  the  trial  balance  of  the  Ledger  of 
Amos  Baldwin  as  at  Dec.  31,  1918: 


DEPRECIATION,  BAD  DEBTS,  ETC.  83 

Amos  Baldwin,  Capital. $25,000.00 

Interest  Accrued 56 .  40 

Accounts  Receivable $  4,056.00 

Accounts  Payable 5,000. 00 

Reserve  for  Bad  Debts 55 .  00 

Store  Building  and  Land 15,500.00 

Rent  of  Delivery  Equipment 1,500. 00 

Purchases 10,000. 00 

Sales 12,500.00 

Inventory,  Nov.  30,  1918 15,600.40 

Cash 700.00 

Furniture  and  Fixtures 500 .  00 

Reserve  for  Depreciation  of  Store  Building 690.00 

Reserve  for  Depreciation  of  Furniture  and  Fixtures  115 .  00 

Expenses 1,200.00 

Mortgage 5,640.00 


$49,056.40     $49,056.40 


Additional  data:  The  inventory  as  of  Dec.  31,  1918,  is 
$16,000.00.  Write  off  for  bad  debts  for  December  an  amount 
equivalent  to  y^  of  1  per  cent  of  the  total  of  accounts  receivable. 
The  store  building  cost  $14,000  and  has  an  estimated  residual 
value  of  $2,000.00.  Write  off  depreciation  for  the  month  on 
the  basis  of  an  assumed  useful  life  of  48  years.  Write  off 
depreciation  on  furniture  and  fixtures  at  the  yearly  rate  of  12% 
on  cost.  The  mortgage  bears  interest  at  the  rate  of  6%  payable 
semi-annually,  September  30  and  March  31. 

Submit  (a)  adjustment  and  closing  entries,  and  (6)  a  profit 
and  loss  account,  and  (c)  a  balance  sheet. 

Note. — In  this  problem  the  accounting  period  is  one  month, 
and  the  adjustment  for  the  interest  on  the  mortgage  must  be 
made  on  this  basis.  In  bringing  into  the  books  the  charge  for  bad 
debts,  by  means  of  a  journal  entry,  either  the  Bad  Debts  account 
or  the  Profit  and  Loss  account  may  be  charged  when  the  Reserve 
for  Bad  Debts  accounts  is  credited.  It  is  suggested  that  the 
first  method  be  followed,  the  entry  being  an  adjustment  pre- 
liminary to  closing. 

The  purpose  of  the  adjustment  entry  charging  Bad  Debts 
and  setting  up  a  Reserve  for  Bad  Debts  is  to  enable  us  to  charge 
Profit  and  Loss  with  the  current  period's  due  burden  of  expense 
arising  from  uncollectible  debts.  Experience  proves  that  we 
may  expect  a  loss  of  this  kind,  which  will  vary  with  different 
lines  of  business,  but  which  in  a  given  line  and  under  given  con- 


84  ACCOUNTS  IN  THEORY  AND  PRACTICE 

ditions  remains  fairly  uniform  from  month  to  month.  The 
advantages  of  charging  Bad  Debts  and  crediting  a  reserve  are 
two:  (a)  the  current  period  is  charged  with  its  due  burden,  where- 
as it  would  be  deferred  if  we  waited  until  we  can  learn  what 
accounts  are  bad;  (b)  the  bu)  den  is  evenly  distributed  from  month 
to  month.  When  individual  accounts  are  ascertained  to  be  bad, 
they  are  charged  against  the  bad  debts  reserve.  Should  experi- 
ence prove  that  the  credits  to  this  reserve  are  greater  than  the 
charges  against  it  of  the  uncollectible  accounts,  it  would  be 
an  indication  that  too  much  is  being  charged  periodically  to 
Bad  Debts  and  credited  to  the  reserve.  The  amount  reserved 
should  then  be  lessened  by  a  suitable  amount. 

BIBLIOGRAPHY 
Part  I.  Fundamental  Principles 

Boole,  A.  M.  Comprehensive  Bookkeeping.  New  York,  1905.  A  clearly 
written  treatise  of  elementary  character,  giving  many  exercises. 

Cole,  W.  M.  Accounts:  Their  Construction  and  Interpretation.  Re- 
vised and  Enlarged  Edition.  Boston,  1915.  Chapters  one  to  five, 
inclusive,  give  much  material  of  an  elementary  character. 

Dickinson,  A.  L.  Accounting  Practice  and  Procedure.  New  York,  1913. 
Chapter  I  contains  a  brief  treatise  on  bookkeeping,  but  not  adapted 
for  the  beginner. 

EsQUERRE,  P.  J.  Applied  Theory  of  Accounts.  New  York,  1914.  Con- 
tains chapters  on  both  single  and  double  entry. 

Oilman,  S.  Principles  of  Accounting.  Chicago,  1916.  Employs  the 
graphic  method  to  assist  the  beginner. 

Haskins,  C.  W.  Business  Education  and  Accountancy.  New  York,  1904. 
A  book  of  general  interest  to  students  of  accounts. 

Hatfield,  H.  R.  Modern  Accounting.  New  York,  1909.  Chapters  1 
and  II  treat  the  theory  of  double  entry  in  considerable  detail. 

Kester,  R.  B.  Accounting  Theory  and  Practice,  Vol.  I.  A  First  Year 
Text.  New  York,  1917.  Presents  the  theory  and  practice  of  double 
entry  at  length. 

Klein,  J.  J.  Elements  of  Accounting.  New  York,  1913.  Gives  a  brief 
treatment  of  double  entry. 

Leake,  P.  D.  Depreciation  and  Wasting  Assets.  London,  1917.  Treats 
depreciation  from  the  English  point  of  view. 

Lisle,  G.  Accounting  in  Theory  and  Practice.  Edinburgh,  1900.  Treats 
the  subject  from  the  English  point  of  view. 

Paton,  W.  a.  and  Stevenson,  R.  A.  Principles  of  Accounting.  New 
York,  1918.  Contains  considerable  material  on  the  theory  of  double 
entry. 


DEPRECIATION,  BAD  DEBTS,  ETC.  85 

Saliebs,  E.  a.  Principles  of  Depreciation.  New  York,  1915.  A  general 
treatise  on  depreciation.     Contains  a  selected  bibliography. 

Sprague,  C.  The  Philosophy  of  Accounts.  New  York,  1908.  A  theo- 
retical treatise  on  accounting. 

Vanderlip,  F.  a.  Business  and  Education.  New  York,  1907.  A  book  of 
general  interest. 


PART  II 

PARTNERSHIP  ACCOUNTING 

CHAPTER  XIII 
THE  PARTNERSHIP— SPECIAL  CONSIDERATIONS 

Value  of  the  Partnership  Form. — Partnerships  afford  a  variety 
of  legal  problems  which  influence  accounting  procedure.  The 
student  should  make  his  consideration  of  them  a  preliminary  to 
his  study  of  partnership  accounting.  Although  the  corporation 
has  superceded  the  partnership  in  many  fields  there  are  many 
kinds  of  enterprise  to  which  the  partnership  is  well  adapted. 

If  it  is  necessary  to  appeal  to  a  large  number  of  investors  to 
secure  necessary  funds  the  corporation  is  ordinarily  best  suited 
for  the  purpose.  However,  there  is  a  very  considerable  class  of 
undertakings  which  depend  to  a  great  degree  upon  personal  or 
professional  qualifications.  These  take  the  form  of  partnerships 
or  of  "  personal  service  corporations. "  The  Income  Tax  Law  of 
1918,  for  purposes  of  taxation,  places  the  personal  service  cor- 
poration in  the  same  class  with  partnerships  and  defines  such  a 
corporation  as  one  "whose  income  is  to  be  ascribed  primarily  to 
the  activities  of  the  principal  owners  or  stockholders  who  are 
themselves  regularly  engaged  in  the  active  conduct  of  the  affairs 
of  the  corporation  and  in  which  capital  (whether  invested  or 
borrowed)  is  not  a  material  income-producing  factor. " 

Partnerships  Classified. — For  certain  purposes  it  is  best  to 
consider  personal  service  corporations  as  partnerships.  Thus 
under  the  Income  Tax  Act  of  1918  the  personal  service  corpora- 
tion is  taxed  upon  the  same  plan  as  the  partnership,  that  is,  the 
tax  is  levied  upon  the  individual  members  and  not  upon  the 
corporation  as  such.     We  have,  therefore: 

1.  Common  law  partnerships 

2.  Limited  partnerships 

3.  Personal  service  corporations 

87 


88  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Common  Law  Partnerships. — When  reference  is  made  to 
partnerships  without  limitations  or  quahfication  it  may  be 
assumed  that  common  law  partnerships  are  meant.  These  are 
governed,  not  by  statute,  but  by  the  common  law,  which  is 
simply  the  common  law  as  developed  in  England  by  the  courts 
and  which  now  serves  as  the  basis  of  our  legal  system.  The 
common  law  may  be  modified  by  statute.  There  are  certain 
fundamental  principles  applicable  to  common  law  partnerships, 
the  most  important  being  the  unhmited  liability  of  the  partners. 
According  to  this  principle  a  partner  is  liable  for  the  debts  of 
the  partnership  to  the  full  amount  of  his  private  fortune. 

Limited  Partnerships. — Practically  all  states  have  passed 
laws  making  it  possible  for  partnerships  to  place  restrictions  on 
the  liability  of  some  of  the  partners  by  following  out  a  pre- 
scribed procedure.  Those  partners  who  are  limited  in  liability 
to  their  investments  are  known  as  "special"  partners  while  those 
who  retain  unlimited  liability  are  known  as  general  partners. 
For  these  the  law  usually  requires  that  a  certificate  be  deposited 
in  a  public  office  stating: 

1.  Name  of  the  firm. 

2.  Name  and  residence  of  each  partner,  and  whether  special  or  general. 

3.  Character  of  the  business. 

4.  Amount  invested  by  each  partner. 

5.  Amount  of  the  capital. 

6.  Duration  of  partnership. 

In  Pennsylvania  and  a  few  other  states  the  law  authorizes  the 
formation  of  partnerships  with  limited  liability  for  all  partners, 
provides  for  the  transfer  of  partnership  shares,  and  permits  the 
holding  of  real  estate  and  the  bringing  of  suit  in  the  common 
name.  Such  partnerships  resemble  corporations  more  than  they 
do  ordinary  partnerships.  The  more  common  plan,  however,  as 
typified  in  the  New  York  laws,  is  to  provide  limited  liability  for 
the  special  partners  only,  leaving  the  general  partners  in  the 
status  of  common  law  partners,  by  making  death  or  attempted 
transfer  of  the  interest  of  a  general  partner  a  basis  of  dissolution, 
and  by  making  the  holding  of  real  estate  or  suing  in  the  partner- 
ship name  impossible.  Limited  partnerships  in  Michigan  and 
Illinois  and  special  partnerships  in  California  are  in  this  class. 
Partnership  associations  in  Michigan  and  in  Virginia  are  corpo- 
rate in  nature. 


THE  PARTNERSHIP— SPECIAL  CONSIDERATIONS         89 

Personal  Service  Corporations. — The  Bureau  of  Internal 
Revenue  defines  a  personal  service  corporation  as  one  "the 
income  of  which  is  derived  from  a  profession  or  business  (o) 
which  consists  principally  of  rendering  personal  service,  (6)  the 
earnings  of  which  are  to  be  ascribed  primarily  to  the  activities 
of  the  principal  owners  or  stockholders,  and  (c)  in  which  the 
employment  of  capital  is  not  necessary  or  is  only  incidental."^ 
Whether  any  given  corporation  is  a  personal  service  corporation 
or  not  can  be  determined  only  by  examination.  It  is  sufficient 
for  our  purpose  to  know  that  for  most  accounting  purposes  the 
personal  service  corporation  is  not  different  from  other  corpora- 
tions. The  distinction  has  been  made  chiefly  for  purposes  of 
taxation. 

General  Definitions. — The  English  Partnership  Act  of  1890 
defined  a  partnership  as  "the  relation  which  subsists  between 
persons  carrying  on  a  business  with  a  view  of  profit." 

The  New  York  law  says  that  "a  partnership  as  between  the 
members  thereof  is  the  association,  not  incorporated,  of  two  or 
more  persons  who  have  agreed  to  combine  their  labor,  property 
and  skill,  or  some  of  them,  for  the  purpose  of  engaging  in  any 
lawful  trade  or  business  and  sharing  the  profits  and  losses  as 
well  between  them." 

Articles  of  Agreement. — -It  is  customary  for  prospective  part- 
ners to  form  a  covenant  wherein  they  agree  upon  the  manner  in 
which  their  enterprise  shall  be  managed.  Unforeseen  discrep- 
ancies frequently  arise  due  to  the  failure  to  put  into  the  articles 
of  agreement  adequate  provision  against  future  contingencies. 
In  addition  to  the  name,  address,  purpose  and  duration  of  the 
partnership  there  should  appear  in  the  articles  of  agreement 
specific  information  as  to: 

1.  Capital  to  he  invested  by  the  Individual  Partners. — Not  only 
should  the  proportions  and  amounts  of  the  contributions  be 
stated  but  also  the  proportions  in  which  it  is  to  be  distributed  at 
dissolution.  Full  provision  should  be  made  here  for  the  admis- 
sion of  new  partners  and  for  such  adjustments  of  goodwill  as 
may  be  necessary  at  that  time.  It  should  be  remembered  that 
if  there  is  no  agreement  to  the  contrary  the  excess  of  the  assets 
over  capital,  after  creditors  are  satisfied,  is  divisible  on  the  same 
basis  as  profits  on  the  theory  that  such  excess  represents  accumu- 
lated profits. 

'  Regulationt)  45,  Art.  1523. 


90  ACCOUNTS  IN  THEORY  AND  PRACTICE 

2.  Provision  regarding  interest  to  be  allowed  on  capital  in- 
vested by  partners. 

3.  Provision  regarding  the  division  of  profits  and  losses  among 
partners.  In  the  absence  of  provision  to  the  contrary  these  are 
allocated  equally  to  the  partners. 

4.  Treatment  of  withdrawals. 

5.  Regulations  for  Admission  of  New  Partners. — It  is  often 
desirable  as  a  preliminary  to  adjust  book  values  so  that  they  will 
agree  with  real  values,  especially  when  goodwill  exists. 

6.  Provision  should  be  made  regarding  the  keeping  of  the 
records,  preferably  by  double  entry,  and  periodical  audits  by 
expert  accountants  should  be  provided  for. 

7.  Rules  to  Govern  Dissolution. — Unless  there  is  provision  to 
the  contrary  any  excess  of  assets  over  capital,  after  creditors  are 
satisfied,  will  be  divided  equally  among  the  partners,  on  the 
theory  that  such  excess  represents  accumulated  profits. 

Other  Provisions  in  the  Agreement. — The  provisions  made  in 
the  articles  of  agreement  need  not  be  limited  to  the  above  and 
in  any  case  special  conditions  arising  from  individual  circum- 
stances may  make  special  clauses  desirable.  Dicksee  suggests 
that  the  name  of  the  auditor  be  inserted  in  the  agreement  so 
that  a  substitute  auditor  could  be  secured  only  with  the  un- 
animous consent  of  the  partners — such  consent  being  always 
necessary  to  change  the  articles  of  agreement.  This  would 
prevent  changes  being  made  by  a  majority  of  partners  to  the 
prejudice  of  a  minority — a  not  unlikely  occurrence  in  view  of  the 
delicate  questions  that  may  arise  in  partnership  adjustments. 
It  may  also  be  desirable  to  enter  in  the  agreement  provision  to 
the  effect  that  the  accounts  be  kept  by  double  entry  and  that 
questions  involving  accounting  principles  be  submitted  to  the 
auditor  for  settlement. 

The  agreement  ought  to  enter  into  sufficient  detail  regarding 
the  interest  question  to  prevent  possible  future  misunderstand- 
ing. This  involves  the  question  of  drawings.  It  may  be  desirable 
to  establish  a  prescribed  limit  to  drawings,  interest  being  charged 
on  any  excess  over  the  prescribed  amount  and  credited  on  any 
excess  of  the  amount  prescribed  and  that  actually  withdrawn. 

Provision  to  Avoid  Dissolution. — Since  the  partnership  is  a 
strictly  personal  arrangement  any  occurrence  which  interrupts 
such  arrangement  is  sufficient  cause  for  dissolution,  no  provision 
occurring  to  the  contrary  in  the  agreement.     This  is  a  common 


THE  PARTNERSHIP— SPECIAL  CONSIDERA  TIONS         91 

law  dictum.  Such  events  are  apt  to  occur  at  times  when  to  make 
an  accounting  by  closing  the  books  would  cause  inconvenience. 
If  profits  do  not  fluctuate  greatly  provision  should  be  made  to 
the  effect  that  the  outgoing  partner  or  his  estate  be  compensated 
on  the  basis  of  the  preceding  year's  profits.  It  will  perhaps  be 
preferable  to  make  such  payment  on  the  instalment  plan  to 
avoid  the  disbursement  of  too  great  an  amount  at  one  time. 

Causes  of  Dissolution. — A  partnership  may  be  dissolved  (o) 
by  arrival  of  a  time  predetermined  by  agreement,  (6)  by 
unanimous  consent  of  the  partners,  (c)  by  the  illegality  of  its  pur- 
pose or  the  impossibility  of  accomplishing  it,  {d)  by  assignment 
of  a  partner's  interest  without  the  consent  of  the  other  partners, 
(e)  by  death  of  a  partner,  and  (/)  by  anything  which  incapaci- 
tates a  partner  for  his  duties,  as  insanity,  bankruptcy,  drunken- 
ness, and  so  on. 

Distribution  of  Assets  at  Dissolution. — At  the  dissolution  of  a 
partnership  the  interested  parties  are  satisfied  in  the  following 
order: 

1.  Creditors. 

2.  Loans  from  partners. 

3.  Capital  of  partners. 

4.  Residue  distributed  among  partners  in  the  profit  and  loss  sharing 
ratio. 


CHAPTER  XIV 
THEORY  OF  PARTNERSHIP  ACCOUNTING 

Peculiarities  of  Partnership  Accounting. — In  general,  partner- 
ship accounting  follows  the  principles  which  we  have  already 
discussed.  The  chief  variations  from  the  procedure  followed  in 
case  of  sole  proprietors  arise  in  connection  with  the  treatment  of 
capital  investments  and  the  allocation  of  the  net  profits  among 
the  partners.  We  have  considered  some  of  the  common  law 
principles  that  govern  partnerships  and  also  certain  of  the  varia- 
tions therefrom  prescribed  by  statute.  We  are  now  prepared  to 
study  the  accounting  procedure  peculiar  to  partnerships.  These 
may  be  considered  under  the  following  heads: 

1.  Opening  entries. 

2.  Interest  on  investments. 

3.  Closing  entries. 

4.  Dissolution. 

5.  Admission  of  partners. 

Opening  Entries. — Opening  entries  for  partnerships  should 
express  clearly  the  contribution  made  by  each  partner.  For 
example,  two  individuals  enter  into  a  partnership  with  the  follow- 
ing assets  and  liabilities: 

L.  Gordon 

Assets: 

Cash $  1,000. 00 

Merchandise 4,000.00 

Store  and  Lot 7,000.00 

Accounts  Receivable 2,000.00 

Furniture  and  Fixtures 500 .  00 

Notes  Receivable 3,000. 00 

$17,500.00 
Liabilities: 

Accounts  Payable $  1,.500.00 

Mortgage 3,000.00 

$  4,500.00 
R.  Tarrant 
Assets: 

Cash $10,000.00 

Liabilities: 
None 

92 


THEORY  OF  PARTNERSHIP  ACCOUNTING  93 

The  student  should  note  that  the  question  of  valuation  (i.e., 
determination  of  value  or  worth)  has  been  introduced  in  con- 
nection with  such  items  as  merchandise,  store  and  lot,  and  good- 
will. Perhaps  the  records  of  the  cost  of  merchandise  and  of 
store  and  lot  are  incomplete,  untrustworthy,  or  lost.  Their 
value  in  dollars  and  cents  must  therefore  be  fixed,  also  that  of  the 
goodwill,  which  is  not  the  result  of  a  purchase  but  of  general 
business  ability  and  foresight. 

It  may  be  agreed  that  Tarrant's  investment  is  to  entitle  him 
to  half  the  profits  and  an  interest  in  the  total  investment  pro- 
portionate to  his  contribution.  Or  it  may  be  agreed  that  his 
contribution  entitles  him  to  a  half  interest  in  the  assets,  in  which 
case  it  is  necessary  to  adjust  the  capital  accounts  of  the  partners 
so  that  they  will  be  equal.  If  we  accept  the  interpretation  that 
his  interest  in  the  total  investment  is  to  be  proportionate  to  his 
contribution  the  opening  entry  is: 

L.  Gordon  and  R.  Tarrant  this  day  enter  into  a  partnership  under  the 
firm  name  of  Gordon  and  Tarrant,  with  assets,  liabilities  and  capital  as 
follows : 

Cash $  1,000.00 

Merchandise 4,000.00 

Store  and  Lot 7,000.00 

Accounts  Receivable 2,000 .  00 

Furniture  and  Fixtures 500.00 

Notes  Receivable > 3,000.00 

To  Accounts  Payable $  1,500. 00 

Mortgage 3,000. 00 

L.  Gordon,  Capital 13,000.00 

Investments  of  L.  Gordon  in  firm  of  Grordon 
&  Tarrant. 

Cash $10,000. 00 

To  R.  Tarrant,  Capital $10,000.00 

Investment  of  R.  Tarrant  in  firm  of  Gordon 
&  Tarrant. 

If  nothing  to  the  contrary  appears  in  the  agreement  Gordon 
and  Tarrant  will  share  equally  in  the  profits  although  their 
investments  stand  as  13  and  10.  If,  however,  it  is  desired  that 
Tarrant  receive  a  half  interest  in  the  business  it  will  be  necessary 
to  adjust  his  capital  account  either  (a)  by  charging  Gordon's 
capital  and  crediting  Tarrant's  capital  account  with  one-half  the 
difference  between  them,  viz.,  $1,500,  or  (6)  by  bringing  in  good- 
will at  $3,000  as  a  part  of  Tarrant's  investment.  In  case  of  (o) 
the  adjusting  entry  is: 


94  ACCOUNTS  IN  THEORY  AND  PRACTICE 

L.  Gordon,  Capital $1,500 

To  R.  Tarrant,  Capital $1,500 

To  equalize  the  partners'  capital  accounts. 

while  in  case  of  (6)  the  original  entry  for  Tarrant,  instead  of  the 
above,  would  be: 

Cash $10,000 

Goodwill 3,000 

To  R  Tarrant,  Capital $13,000 

Investment  of  R.  Tarrant  in  firm  of  Gordon  &  Tarrant. 

In  the  same  manner  the  capital  accounts  of  the  two  partners 
may  be  established  in  any  desired  ratio  to  each  other,  either  by 
bringing  goodwill  into  the  books,  or  by  making  adjustments  be- 
tween the  capital  accounts  of  the  partners.  There  is  no  objection 
to  bringing  goodwill  into  the  books  if  it  is  done  to  represent  a 
real  condition,  that  is,  if  the  partner  whose  account  is  increased 
by  the  amount  charged  to  goodwill  really  brings  into  the  business 
connections  of  value  equal  to  that  ascribed  to  goodwill.  If, 
however,  the  proper  ratio  between  the  partners'  capital  accounts 
cannot  be  thus  secured  it  should  be  done  by  adjustments  made 
between  the  capital  accounts. 

Interest  on  Investments. — The  interest  question  arises  in  two 
ways  in  partnership  accounting:  (o)  as  a  means  of  adjusting 
profits  and  (6)  as  a  charge  or  credit  in  connection  with  with- 
drawals by  the  partners.  Thus  when  interest  is  employed  to 
adjust  profits  it  is  done  with  a  view  to  granting  something  more 
than  the  rule  of  equal  division  of  profits  would  give  to  the  partner 
whose  investment  is  greater  than  the  average  and  something  less 
than  that  rule  would  gi.ve  to  the  partner  whose  investment  is 
below  the  average.  For  example,  if  A,  B,  and  C  invest  $50,000, 
$75,000  and  $100,000,  respectively,  the  average  investment  is 
$75,000,  and  if  each  partner  is  credited  with  6%  on  his  capital 
account,  {i.e.,  this  interest  is  to  be  carried  to  Profit  and  Loss') 
then  the  accounts  of  the  partners  will  be  credited  with  the  follow- 
ing amounts  for  interest: 

A $  3,000 

B 4,500 

C 6,000 

Total  interest $13,500 

The  $13,500  will  be  charged  to  Profit  and  Loss  with  the  resQlt 
that  each  partner  will  bear  }^  of  its  cost,  or  $4,500.    We  see 


THEORY  Of  PARTNSRSftlP  ACCOVNTtNG  95 

that  B,  whose  investment  was  just  equal  to  the  average  invest- 
ment of  the  partners,  or  $75,000,  neither  gains  nor  loses  by  the 
procedure,  and  that  A  secures  $1,500  less  and  C  $1,500  more 
than  would  be  the  case  were  the  partners  not  credited  with 
interest  on  their  capital  accounts.  This  net  result  might  have 
been  accomplished  by  the  following  adjustment: 

A $1,500 

C $1,500 

This  avoids  carrying  the  interest  to  the  Profit  and  Loss  account 
and  since  the  effect  is  merely  an  adjustment  of  profits  as  between 
partners  it  appears  to  be  more  logical  than  to  credit  each  partner's 
account  with  6%  of  its  amount,  and  charge  it  with  }^  of  the 
total  interest,  thus  bringing  it  into  the  Profit  and  Loss  account. 

When  profits  are  distributed  to  partners  in  proportion  to  invest- 
ments, the  only  object  is  to  distinguish  between  interest  on  the 
amounts  invested  and  profits  beyond  that,  since  each  partner 
will  be  credited  with  the  same  amount  as  if  interest  were  not 
considered  at  all.  In  this  case  it  is  necessary  to  carry  interest 
to  Profit  and  Loss. 

If  the  agreement  provides  for  allowing  interest  on  the  average 
investment  of  the  partners,  then  any  withdrawals  or  contributions 
made  during  the  year  by  the  partners  must  be  taken  into  con- 
sideration together  with  the  time  during  which  they  are  with- 
drawn or  invested.  If  two  partners,  A  and  B,  respectively, 
invest  $5,000  and  $10,000  on  January  1st  and  make  the  following 
withdrawals  and  additional  investments: 

Withdrawals: 

A  March  31st $100.00 

Sept.  30th 200.00 

B  April  30th $  50.00 

July  31st 75 .  00 

Oct.  31st 90.00 

Additional  Investments: 

A  June  30th $1,000.00 

B  March  31st 2,000.00 

then  at  the  end  of  the  year  A  has  invested: 

$5,000  for  12  mo.  or  $60,000  for  1  mo. 
1,000  for    6  mo.  or      6,000  for  1  mo. 

or  $66,000  for  1  mo. 

He  has  withdrawn: 


96  ACCOUNTS  IN  THEORY  AND  PRACTICE 

$100  for  9  mo.  or     $900  for  1  mo. 
200  for  3  mo.  or       600  for  1  mo. 


or  $1,500  for  1  mo. 

Therefore  his  investment  is  $66,000  -  $1,500,  or  $64,500  for  1  month,  or  an 
average  investment  of  (64,500  -^  12)  $5,375.  Similarly  at  the  end  of  the 
year  B  has  invested: 

$10,000  for  12  mo.  or  $120,000  for  1  mo. 
2,000  for    9  mo.  or      18,000  for  1  mo. 


or  $138,000  for  1  mo. 

He  has  withdrawn: 

$50  for  8  mo.  or  $400  for  1  mo. 
75  for  5  mo.  or  375  for  1  mo. 
90  for  2  mo.  or    180  for  1  mo. 

or  $955  for  1  mo. 

and  his  investment  is  $138,000  -  $955,  or  $137,045  for  1  month, 
or  an  average  investment  of  (137,045  -f-  12)  $11,420.42.  In- 
terest will  then  be  calculated  on  A's  average  investment  of 
$5,375  and  on  B's  average  investment  of  $11,420.42. 

Closing  Entries. — In  general  the  closing  entries  for  a  partner- 
ship are  not  essentially  different  from  those  of  a  single  pro- 
prietor. Before  they  can  be  made,  however,  all  requirements 
regarding  interest  on  investments  must  be  met  because  it  may 
be  necessary,  as  shown  above,  to  carry  this  interest  through 
the  Profit  and  Loss  account.  Whether  or  not  this  is  done  the 
balance  of  Profit  and  Loss  must  be  transferred  to  the  capital 
acco'jnts  according  to  an  accepted  ratio,  or,  in  the  absence  of  an 
agreement,  it  is  divided  equally.  The  balances  in  the  withdrawal 
accounts  are  not  carried  to  the  Profit  and  Loss  account  because 
they  do  not  represent  disbursements  made  for  the  business  but 
for  the  benefit  of  the  partners  personally.  They  must  therefore 
be  carried  to  the  partners'  capital  accounts.  The  usual  plan 
is  to  bring  the  net  profits  into  the  withdrawal  accounts  and  then 
carry  the  balance  to  capital.  Thus  if  A,  B,  and  C  are  partners 
sharing  equally  in  profits,  if  the  balance  indicating  net  profits 
in  the  Profit  and  Loss  account  is  $15,000,  and  if  A,  B,  and  C  are 
charged  $100,  $200  and  $300,  respectively  in  their  withdrawal 
account,  then  the  entries  to  carry  profits  to  the  withdrawal 
accounts  and  thence  to  the  capital  accounts  are: 


THEORY  OF  PARTNERSHIP  ACCOUNTING 


97 


Profit  and  Loss $15,000 

To  A,  Withdrawals $5,000 

B,  Withdrawals 5,000 

C,  Withdrawals 5,000 

To  carry  profits  to  partners'  withdrawal  accounts. 

A,  Withdrawals $  4,900 

To  A,  Capital $4,900 

B,  Withdrawals $  4,800 

To  B,  Capital $4,800 

C,  Withdrawals $  4,700 

To  C,  Capital $4,700 

To  carry  net  profits  retained  in  the  business  to  the 
partners'  capital  accounts. 

The  partner's  withdrawal  accounts  now  appear  thus : 

A,  Withdrawals 


To  Cash 

$    100.00 

By  Profit  and  Loss. . . 
Ldrawals 

.   $5,000  00 

To  A,  Capital 

....     4,900.00 

$5,000.00 
B,  Witl 

$5,000.00 

To  Cash 

$    200.00 

By  Profit  and  Loss. .  . 
ldrawals 

$5,000  00 

To  B,  Capital 

....     4,800.00 

$5,000.00 
C,  Witl 

$5,000.00 

To  Cash 

$    300  00 

By  Profit  and  Loss . .  . 

. ..   $5,000.00 

To  C,  Capital 

....     4,700.00 

$5,000.00 

$5,000  00 

Dissolution. — In  the  preceding  chapter  we  have  seen  that  the 
same  principle  that  governs  distribution  of  profits  does  not  govern 
the  distribution  of  assets  in  case  of  dissolution.  In  theory  capital 
invested  is  returned  to  the  partners  at  dissolution  in  the  same  ratio 
in  which  it  was  invested.  Any  increase  in  the  value  of  the  in- 
vestment over  the  contributions  by  the  partners  represents 
accumulated  profits  and  is  governed  by  the  rule  for  distribution 
of  profits  and  losses.  Likewise  a  deficit  represents  accumulated 
losses  and  is  governed  by  the  same  rule.  Consequently  the 
first  step  in  the  distribution  of  funds  is  to  divide  the  accumulated 

7 


98  ACCOUNTS  IN  THEORY  AND  PRACTICE 

profits  or  the  deficit  among  the  partners  according  to  the  rule 
governing  division  of  losses  and  gains,  after  which  remaining 
values  are  distributed  to  partners  in  proportion  to  their  capital 
accounts.  In  case  of  a  deficit  the  ratio  of  the  partners'  capital 
accounts  will  be  changed,  except  when  profits  or  losses  are 
distributed  in  the  ratio  of  the  investments,  because  they  will 
be  reduced  by  amounts  whose  ratio  to  one  another  is  the  basis 
of  profit  distribution. 

Assume  that  the  balance  sheet  of  A  and  B  is  as  follows: 

Balance  Sheet — A  and  B — as  at — 

Assets $50,000      Capital,  A $50,000 

Deficit 20,000     Capital,  B 20,000 


$70,000  ^  $70,000 


If  profits  are  distributed  equally  the  deficit  will  be  charged  3^^ 
to  A  and  ^  to  B  and  the  balance  sheet  becomes: 

Balance  Sheet — A  and  B — as  at — 

Assets $50,000     Capital,  A $40,000 

Capital,  B 10,000 


$50,000  $50,000 


and  the  distribution  of  the  assets  will  be  made  to  A  and 
B  in  the  ratio  of  4  to  1,  not  of  5  to  2,  the  ratio  of  the  original 
investments. 

It  is  quite  possible  that  the  distribution  of  the  deficit  to  the 
partners'  capital  accounts  on  the  profit  and  loss  sharing  ratio 
will  change  the  capital  account  of  a  partner  to  a  deficit  account, 
in  which  case  the  other  partners  have  a  claim  against  him  for 
the  amount  of  the  deficit.  Thus  when  the  following  balance 
sheet,  showing  a  deficit  of  $60,000: 

Balance  Sheet  of  A,  B,  C,  and  D,  as  at — 

Assets $  40,000     A,  Capital $  50,000 

Deficit 60,000     B,  Capital '. . .  10,000 

C,  Capital 20,000 

D,  Capital 20,000 

$100,000  $100,000 


THEORY  OF  PARTNERSHIP  ACCOUNTING  99 

is  altered  to  show  the  distribution  of  the  deficit  equally  among  the 
partners  it  becomes: 

Balance  Sheet  of  A,  B,  C,  and  D,  as  at — 

Assets $40,000     A,  Capital $35,000 

B,  Capital 5,000      C,  Capital 5,000 

D,  Capital 5,000 

$45,000  $45,000 

If  B  makes  good  the  claim  against  him  for  $5,000  the  other 
partners  will  receive  the  assets  in  distribution  as  shown  by  their 
capital  accounts.  If  he  fails,  however,  this  loss  must  in  turn 
be  distributed  among  A,  C  and  D  equally,  each  bearing  $1,666.67 
of  the  loss,  after  which  the  distribution  will  be  made  on  the 
basis  of  the  capital  account  balances  then  remaining. 

Admission  of  Partners. — When  a  new  partner  is  admitted  his 
contribution  entitles  him  to  share  equally  with  the  other  partners 
in  profits  no  matter  what  the  amount  of  his  investment,  unless 
there  is  an  agreement  to  the  contrary.  If  it  is  specifically  agreed 
that  he  is  to  share  equally  with  the  other  partners  in  proprietor- 
ship then  it  may  be  necessary  to  make  adjustments  to  establish 
the  desired  ratio  among  the  capital  accounts.  Thus  if  the 
following  is  the  balance  sheet  of  A  and  B: 

Balance  Sheet  of  A  and  B,  as  at — 

Cash $  1,000      A,  Capital $  5,500 

Other  assets 10,000      B,  Capital 5,500 


$11,000  $11,000 


and  they  agree  to  admit  C  to  the  partnership,  giving  him  a  3i 
interest  on  condition  that  he  invest  $7,000,  then  it  is  necessary 
either, 

(a)  to  bring  goodwill  into  the  books,  according  to  some  agree- 
ment between  A  and  B,  or 

(6)  to  make  an  adjustment  among  the  capital  accounts  without 
introducing  goodwill. 

If  the  plan  suggested  in  (a)  above  is  followed  the  following 
Journal  entry  is  necessary  to  bring  goodwill  into  the  books: 


100  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Goodwill $3,000 

To  A,  Capital $1,500 

B,  Capital 1,500 

To  bring  goodwill  into  the  books,  etc. 

The  capital  accounts  of  A  and  B  are  both  increased  to  $7,000 
and  when  C  contributes  his  share  the  capital  accounts  of  each 
of  the  three  partners  will  stand  at  that  amount. 

If  the  plan  suggested  in  (b)  above  is  followed  the  following  entry 
made  after  C  invests  his  $7,000  will  equalize  the  capital  accounts 
of  A,  B  and  C: 

C,  Capital $1 ,000 

To  A,  Capital S500 

B,  Capital 500 

As  per  agreement,  etc. 

A  different  problem  arises  when  a  party  buys  an  interest  in  a 
partnership  without  contributing  anything  to  the  partnership. 
Here  entrance  to  the  partnership  is  secured  by  a  transfer  of 
interest  to  the  new  partner,  not  by  the  investment  of  new  money. 
Thus  if  the  following  is  the  balance  sheet  of  A  and  B : 

Balance  Sheet  of  A  and  B,  as  at — 

Assets. ?100,000      A,  Capital $  60,000 

B,  Capital 40,000 


$100,000  $100,000 


and  A  sells  one-half  of  his  interest  to  C,  the  following  entry  is 
necessary  to  make  the  adjustment, 

A,  Capital $30,000 

To  C,  Capital $30,000 

and  the  balance  sheet  becomes: 

Balance  Sheet  of  A  and  B,  as  at — 

Assets $100,000     A,  Capital $  30,000 

B,  Capital 40,000 

C,  Capital 30,000 


$100,000  $100,000 

Note  that  the  investment  has  not  been  increased  and  that  the 
only  change  has  been  to  transfer  one-half  of  A's  capital  account 
to  C's  capital  account.  The  only  transfer  of  funds  has  been  from 
C  to  A,  personally. 


CHAPTER  XV 
PARTNERSHIP  ACCOUNTING-PRACTICE 

Diary  of  Events — November. — A.  B.  Gray,  owing  to  increasing 
business,  and  the  need  for  more  capital,  has  concluded  to  take 
for  a  partner  Mr.  J.  A.  Smith.  On  condition  of  payment,  by 
Mr.  Smith,  into  the  business  of  $4,000.00  in  cash,  J.  A.  Smith 
is  to  become  a  partner,  under  the  firm  name  of  Gray  and  Smith. 
According  to  the  partnership  agreement,  each  partner  is  to  be 
credited  with  5%  interest  on  his  investment  before  distribution 
of  profits.  Profits  and  losses  are  to  be  shared  equally.  Use 
same  books  as  for  the  October  diary  of  events. 

Nov.  1 .  Make  entry  in  Cash  Journal  for  Smith's  investment  (J.  A.  Smith, 
Capital,  p.  1,  below  A.  B.  Gray,  Capital).  If  desirable,  a  formal  entry  may 
also  be  made  in  the  General  Journal  for  Smith.  This,  both  debit  and 
credit,  should  be  checked  (1/  )  in  the  folio  column  to  show  that  it  is  posted 
from  the  Cash  Journal.  Such  a  formal  journal  entry  is  especially  desirable 
when  it  is  desired  to  enter  considerable  explanatory  matter  relating  to  the 
partnership  organization.  As  all  petty  cash  payments  are  to  be  made 
on  the  Imprest  System  (see  note  below),  a  check  is  written  out  for  $50  and 
charged  to  Petty  Cash  Account  (p.  10).  It  is  calculated  that  this  will  be 
more  than  sufficient  for  all  petty  disbursements  for  2  weeks.  By  petty 
cash  disbursements  is  meant  $5.00  or  less.  Any  payment  over  $5.00  will  be 
made  by  check.  On  a  sheet  of  blank  paper  rule  up  a  page  of  the  Petty 
Cash  Book,  with  the  following  columns:  Remarks;  Telegrams;  Stationery  & 
Printing;  Advertising;  Telephone;  A.  B.  Gray,  Withdrawals;  J.  A.Smith, 
Withdrawals;  General  Expense;  Freight;  Totals.     Cash  sales  $97.00. 

Cash  sales  will  be  given  hereafter  for  each  week  at  the  close  to  save  labor. 

Additional  furniture  for  store  is  ordered  from  Anderson  &  Co. 

Note.  For  description  of  the  Imprest  System  of  cash  payment 
see  Chapter  XVII. 

Nov.  3.  Some  contemplated  improvements  are  carried  out.  The  horses 
and  wagons  are  sold  at  their  book  value  and  an  automobile  delivery  wagon 
is  purchased  for  $1,500,  cash.  An  adjoining  building  is  purchased  for 
$2,000  for  a  storage  house;  $1,500  is  paid  in  cash,  and  a  note  given  for  t.ho 
balance  payable  in  30  days  with  interest  at  6%.  A  contractor  is  secured 
to  make  some  improvements  on  this  building  at  a  cost  of  $500,  one-half 
to  be  paid  on  Nov.  15,  and  the  balance  on  completion  of  the  work. 

101 


102  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Note. — Make  entries  in  Cash  Journal  for  purchases  and  sales 
of  delivery  equipment.  Charge  "Storage  House  No.  2"  for 
the  new  one  purchased.  This  requires  two  entries,  one  in  the 
Cash  Journal  and  one  in  the  General  Journal.  The  information 
regarding  the  contract  requires  no  entry. 

Nov,  4.  Purchase  mdse.  from  Cloverdale  Wholesale  Co.,  2/10,  n/30, 
$975.00.  Telegrams,  $4.20.  Stationary  and  Printing  $3.10.  Sell  on 
account  to  T.  M.  Phillips,  $16.00;  to  D.  Hathaway,  $5.00.  M.  Arnold 
pays  his  account  in  full. 

Nov.  5.  Pay  telephone  bill  for  mo.,  $3.00.  Rent  second  floor  of  store  to 
the  X.  Y.  Z.  Club,  at  monthly  rental  of  $30.00.  Accept  $25  cash  for  rent  in 
advance  for  balance  of  month  (Rents,  p.  10).  Sell  on  account  to  S.  Smith, 
$7.87;  to  T.  Bradford  (new)  $11.00. 

Nov.  6.  General  Expense  $3.35;  telegram,  $1.00.  Sell  on  account  to 
T.  M.  Phillips,  $7.30. 

Nov.  7.  Note  is  received  from  bank  that  bill  of  lading  with  sight  draft 
for  $175.00  attached  has  been  received  from  Anderson  &  Co.  Draft  is 
paid  and  bill  of  lading  secured.     Freight  on  shipment,  $4.00,  paid  in  cash. 

Note. — Charge  Furniture  and  Fixtures  and  credit  cash  when 
sight  draft  is  paid. 

Nov.  8.  Cash  sales  for  week,  $632.14.  L.  Floyd  pays  1510.00  on  account. 
Pay  note  of  $200  due  at  bank. 

Nov.  10.  T.  Bradford  returns  defective  goods  purchased  Nov.  5  and 
receives  credit  for  $5.00.  General  expense,  $3.50.  Sell  on  account,  to 
S.  Smith,  $5.00. 

Nov.  11.  Purchase  of  the  Townsend  Supply  Company,  2%  30  days,  net 
60  days,  mdse.  $432.00. 

Nov.  12.  Owing  to  a  defective  chimney  the  store  takes  fire  and  damage 
is  done  to  the  extent  of  $540.,  as  determined  by  a  board  of  appraisers.  This 
amount  is  paid  over  by  the  insurance  company,  in  which  A.  B.  Gray  had 
insured  his  store.  Make  proper  entries  in  books.  Arrangements  are  at 
once  made  with  a  contractor  for  necessary  repairs,  to  be  paid  for  on  com- 
pletion of  the  work.     (Charge  Cash  and  credit  Store  &  Lot.) 

Nov.  13.  Donate  $5.00  to  Salvation  Army  and  give  $10.00  to  Society  for 
Prevention  of  Tuberculosis.  (Charge  General  Exp.)  Pay  $3.00  for 
advertising  in  local  papers.  Sell  on  account  to  S.  Thomas,  $11.10;  to  T.  M. 
Phillips  $7.00. 

Nov.  14.  Pay  Cloverdale  Wholesale  Company  bill  of  Nov.  4,  less 
discount. 

Nov.  15.  Pay  contractor  $250  in  part  payment  for  improvements  on 
store,  as  per  agreement.  Cash  sales  for  week,  $651.13.  Write  out  check 
for  proper  amount  to  replenish  petty  cash,  charging  proper  accounts.  Pay 
assistants  same  as  on  previous  pay  day.  Sell  on  account  to  B.  Ward, 
$27.32.     T.  M.  Phillips  and  S.  Thomas  pay  their  accounts  in  full. 

Note. — Charge  Store  and  Lot  for  payment  to  contractor. 

Nov,  17,     Sell  op|  account  tP^,  Ritter  (new)  $17.00,     Return  defective 


PARTNERSHIP  ACCOUNTING  PRACTICE  103 

goods  to  Cloverdale  Wholesale  Co.,  receiving  credit  for  $23.00;  and  to  Town- 
send  Supply  Co.,  credit  $13.40. 

Note. — For  mdse.  returned  debit  Sales  and  credit  Cloverdale 
Wholesale  Co. 

Nov.  18.  Purchase  mdse.  from  Armour  and  Co.,  2/10,  n/30,  $200.00, 
From  Cresca  Company  $48.70,  net  30  days.  From  Park  and  Tilford,  $77.00, 
2/10,  n/30.  Open  accounts  in  the  accounts  payable  division  of  the  Ledger. 
General  expense  $4.00,  stationery  and  printing,  $3.50,  telegrams,  $2.30. 
A.  B.  Gray  withdraws  $3.00  from  petty  cash  for  personal  use. 

Nov.  20.  Sell  on  account  to  R.  Ritter  $3.00;  to  B.  Ward,  $7.00;  to  O. 
Freeborn,  $8.00.  Buy  from  Arbogast  and  Bastian  mdse.,  $40.00,  2/20, 
n/30.  They  accept  our  note  payable  in  19  days  for  purchase  of  Nov.  20, 
less  discount.  Make  note  for  $40  less  2%.  Make  proper  Journal  entry 
for  note  and  for  discount.  A^  Arbogast  and  Bastian  desire  payment  we 
offer  to  discount  our  own  note  to  them  at  6%  interest..  They  surrender 
the  note  and  we  pay  them  its  face  less  discount.  Reckon  interest  for 
19/365  of  a  year,  at  6%.  Make  proper  entries.  J.  A.  Smith  withdraws 
$25  for  personal  use.     Cash  sales  for  week,  $695.00. 

Note. — For  purchase  from  Arbogast  and  Bastian  make  entry 
in  General  Journal,  charging  Purchases  and  crediting  Arbogast 
and  Bastian.     Then  make  entry  for  note  thus : 

Arbogast  and  Bastian $40 .  00 

To  Notes  Payable $39.20 

Discount  on  r*urchases .80 

Next  make  entry  for  discount  on  their  note.  The  discount  is 
$0.12.  In  the  Cash  Journal  charge  Notes  Payable  and  credit 
Cash  $39.08.  In  the  General  Journal  charge  Notes  Payable 
and  credit  Interest  $0.08. 

Nov.  23.     B.  Ward  pays  account  in  full. 

Nov.  24.     General  expense,  $3.00;  telegrams,  $1.00. 

Nov.  25.  Sell  on  acct.  to  D.  Hathaway,  $5.00;  to  M.  Arnold,  $20.00: 
to  L.  Floyd,  $40.00. 

Nov.  26.  L.  Floyd  gives  note  for  $40  for  1  mo.,  Int.  at  6%,  for  purchase 
of  Nov.  25. 

Nov.  28.  Armour  &  Co.  accept  out  note;  payable  in  30  days.  Int.  at  6% ; 
for  purchase  of  Nov.  18,  less  discount. 

Nov.  29.  Sells  on  account  to  T.  M.  Phillips  mdse.  $30.00.  Mr.  Phillips 
gives  note  for  his  account  in  full  due  in  20  das..  Int.  at  6%  (20/365  of  one 
year). 

Nov.  30.  Pay  assistants  as  on  preceding  pay-day.  Cash  sales  for  week, 
$702.03.     Telegrams,  $4.00.     Draw  check  to  replenish  petty  cash  fund. 

(a)  Take  a  trial  balance. 

(6)  Make  closing  journal  entries,  among  them  being  those  for  charging 
interest  and  crediting  partners'  accounts,  at  5%. 


104  ACCOUNTS  IN   THEORY  AND  PRACTICE 

(c)  Set  up  profit  and  loss  account. 

(d)  Balance  sheet. 

Inventory,  Nov.  30 $1,200 

Carry  profits  to  the  withdrawal  accounts,  then  close  latter 
into  the  capital  accounts  of  the  partners. 

The  capital  accounts  as  of  Dec.  1  should  stand  with  credit 
balances  as  follows: 

A.  B.  Gray $5,251.31 

J.  A.  Smith 4,336.99 

\  BIBLIOGRAPHY 

Part  II.  Partnership  Accounting 

Child,  P.     Partnership  Accounts.     London,  1904. 

Cole,  W.  M.  Accounts:  Their  Construction  and  Interpretation.  Re- 
vised and  Enlarged  Edition.     Boston,  1915.     Chapter  XXII. 

EsQUERRife,  P.  J.  Applied  Theory  of  Accounts.  New  York,  1914.  Chapter 
XXI. 

Oilman,  S.     Principles  of  Accounting.     Chicago,  1916.     Chapter  IX. 

Greendlinger,  L.  Accountancy  Problems.  New  York,  1910.  Vol. 
I,  pp.  1-40.  Both  volumes  I  and  II  contain  much  miscellaneous 
matter  on  partnership.  Vol.  I,  page  40,  gives  a  brief  bibliography  on 
partnership. 

Hatfield,  H.  R.     Modern  Accounting,  1909.     Chapter  XVII. 

Kester,  R.  B.  Accounting  Theory  and  Practice.  Vol.  I.  New  York, 
1917.     Chapters  XI^XLIV. 

Klein,  J.  J.     Elements  of  Accounting,  New  York,  1913.     Chapter  V. 

Paton,  W.  a.  and  Stevenson,  R.  A.  Principles  of  Accounting.  New 
York,  1918.     Chapter  XI. 

Regulations  45.  Bureau  of  Internal  Revenue,  Washington,  D.  C.  Con- 
tains regulations  promulgated  by  the  Treasury  Department  under  the 
Revenue  Act  of  1918. 


PART  III 
EXPANSION  OF  ACCOUNTING  RECORDS 

CHAPTER  XVI 

SUBORDINATE  LEDGERS  AND  CONTROLLING 
ACCOUNTS 

Records  must  be  Adaptable. — Accounting  records  must  be 
correct  in  principle;  they  must  also  be  adapted  to  actual  con- 
ditions. This  latter  consideration  necessitates  the  introduction 
of  such  alterations  and  additions  to  the  records  as  will  make 
them  at  all  times  adequate  and  satisfactory.  As  a  concern's 
market  widens  its  customers  and  creditors  become  more  numer- 
ous, and  the  sources  of  profit  as  well  as  of  expenses  and  losses 
increase  correspondingly.  Under  such  conditions  the  very 
simple  arrangement  which  consists  of  the  General  and  Cash 
Journals  and  the  Ledger  becomes  inadequate.  The  General 
Journal  is  crowded  with  a  multiplicity  of  entries,  of  which 
many,  probably  the  great  majority,  record  purchases  and  sales  on 
credit. 

Controlling  Accounts  and  Columnar  Journals. — As  far  as  cash 
is  concerned  the  Cash  Journal  remains  an  adequate  record; 
nevertheless  even  here  improvements  for  the  handling  of  certain 
classes  of  receipts  and  disbursements  become  desirable.  The 
growing  number  of  accounts  receivable  and  payable  encumber 
the  Ledger,  making  errors  difficult  to  avoid  and  equally  difficult 
to  locate  after  they  occur.  The  work  of  taking  the  trial  balance 
is  greatly  increased.  With  only  two  Journals  and  one  Ledger 
a  proper  subdivision  of  work  among  clerks  grows  constantly  more 
difficult.     General  inadequacy  of  the  system  results. 

As  a  remedy  for  such  a  situation,  the  ingenuity  of  accountants 
has  succeeded  in  obtaining  not  merely  a  further  subdivision  of 
the  Journal,  but  also  a  subdivision  of  the  Ledger  through  the 
application  of  the  principle  of  controlling  accounts  and  columnar 
Journals.     Briefly,  controlling  accounts  are  accounts  kept  in 

105 


106  ACCOUNTS  IN   THEORY  AND  PRACTICE 

the  General  Ledger  ("general "  being  the  word  used  to  distinguish 
the  main  Ledger  from  the  "subordinate"  Ledgers)  to  which  are 
posted,  from  the  Journals,  the  totals  of  the  debits  and  credits 
which  are  posted  in  detail  to  the  subordinate  Ledgers  which  these 
controlHng  accounts  "control."  The  subordinate  Ledger  is 
frequently  known  by  the  same  name  as  its  controlling  account. 
Thus  if  all  accounts  receivable  are  kept  in  a  subordinate  Ledger, 
that  Ledger  may  be  called  the  Accounts  Receivable  Ledger  and 
its  controlling  account  in  the  General  Ledger  the  Accounts 
Receivable  Controlling  Account.  Similarly  if  the  accounts  pay- 
able are  kept  in  a  subordinate  Ledger,  that  Ledger  may  be  called 
the  Accounts  Payable  Ledger  and  its  controlling  account  the 
Accounts  Payable  Controlling  Account. 

Controlling  accounts  and  subordinate  Ledgers  require  a 
certain  amount  of  specialization,  in  the  forms  of  the  Journals, 
beyond  that  which  we  have  already  described.  First,  it  is  de- 
sirable to  take  out  of  the  General  Journal  those  entries  which 
affect  accounts  in  the  subordinate  Ledgers,  as  far  as  possible, 
or  else  provide  special  columns  in  the  General  Journal  for  their 
reception.  In  the  Cash  Journal,  also,  special  columns  must  be 
provided  for  the  reception  of  these  entries.  By  providing  either 
(a)  special  Journals,  or  (6)  special  columns  in  the  General  and 
Cash  Journals,  or  both,  for  the  reception  of  those  items  which  are 
to  be  posted  in  detail  to  subordinate  Ledgers,  it  is  possible  to  post 
the  totals  of  the  items  entered  in  the  special  Journals  and  in  the 
special  columns  in  the  General  and  Cash  Journals  to  the  con- 
trolling accounts,  thus  fulfilling  the  requirement  mentioned  of 
carrying  to  the  controlling  accounts  the  totals  of  the  debits  and 
credits  which  are  posted  in  detail  to  the  subordinate  Ledgers. 

Controlling  Accounts  Provide  Elasticity. — The  principle  of 
controlling  accounts  permits  of  the  greatest  freedom  and  elas- 
ticity in  the  construction  of  accounting  records.  The  extent  of 
its  application  is  limited  only  by  the  nature  and  magnitude  of 
the  business  to  which  it  is  applied.  There  may  be  as  many 
special  Journals,  and  as  many  special  columns  in  the  General 
and  Cash  Journals,  and  as  many  subordinate  Ledgers,  as  cir- 
cumstances require. 

Specialized  Journals  Illustrated. — To  clarify  this  matter,  let 
us  assume  that  a  merchant,  Marion  Smith,  has  in  operation  a 
system  of  accounts  consisting  of  the  General  and  Cash  Journals 
and  a  Ledger.     With  the  growth  of  his  business  he  experiences 


LEDGERS  AND  CONTROLLING  ACCOUNTS 


107 


certain  difficulties  with  his  accounts.  His  General  Journal  is 
crowded  with  an  excessive  number  of  entries  owing  to  his  numer- 
ous purchases  and  sales.  For  various  reasons  it  would  be  better 
if  purchases  and  sales  could  be  segregated  in  special  Purchases 
and  Sales  Journals.  This  would  not  only  remove  a  large  volume 
of  detail  from  the  General  Journal,  but  it  would  also  make  easy  a 
subdivision  of  labor  among  the  office  force,  hitherto  impossible. 
When  purchases  and  sales  are  entered  in  the  General  Journal  all 
entries  must  either  be  made  therein  by  one  person,  or  the  General 
Journal  must  be  shifted  inconveniently  from  one  person  to 
another.  The  subdivision  of  the  General  Journal  into  three 
Journals,  one  becoming  the  Sales  Journal,  one  the  Purchases 
Journal,  and  one  remaining  the  General  Journal,  obviates  this 
difficulty  by  making  it  easy  for  one  clerk  to  specialize  on  the 
Sales  Journal,  one  on  the  Purchases  Journal,  and  so  on. 
Below  are  shown  forms  for  Sales  and  Purchases  Journals: 


Sales  Journal,  Marion  Smith 


Date 

Name  of  Customer                                      L.F. 

Amount 

Jan. 

3 

3 

12 

A.  L.  Grant 

.     50 
25 
72 

147 

00 
00 
00 

00 

L.  0.  McDonald 

0.  0.  Stout 

Accounts  Receivable,  Dr.  1 
Sales,  Cr.                              J 

Purchases  Journal,  Marion  Smith 


Date 


Name  of  Creditor 


L.F.      Amount 


Jan. 


Atlas  Ck>mpany 

Fuller  Supply  Co 

Oregon  &  Sons , 

Atlas  Co 

Newton  Company 

Accounts  Payable,  Cr 
Purchases,  Dr. 


200 
100 
150 
125 
98 

673 


00 
00 
00 
00 
00 

00 


In  these  specialized  Journals  it  is  necessary  to  use  but  one 
line  for  a  double  entry.     The  customer  is  charged  in  the  Sales 


108  ACCOUNTS  IN   THEORY  AND  PRACTICE 

Journal.  The  party  from  whom  a  purchase  is  made  is  credited 
in  the  Purchases  Journal.  When  a  sale  is  made  the  credit  to 
Sales  need  not  be  shown  separately  in  the  Sales  Journal,  since 
the  total  sales  for  the  month  can  be  obtained  by  adding  the  items 
entered  in  the  amount  column.  This  total  may  then  be  posted 
to  the  credit  of  the  sales  account.  Likewise  in  the  Purchases 
Journal  it  is  unnecessary  to  write  the  word  Purchases  each  time 
an  entry  is  made,  since  the  total  of  the  column  containing  the 
amounts  of  the  purchases  can  be  posted  to  the  purchases  account 
in  the  General  Ledger  at  the  month's  end. 

Specialized  Ledgers. — If,  because  of  the  number  of  customers 
and  creditors,  it  is  necessary  to  provide  special  Journals  for  them, 
it  will  also  be  well  to  supply  subordinate  ledgers  for  the  purpose  of 
keeping  the  accounts  with  these  customers  and  creditors.  These 
are  the  Sales  Ledger  and  the  Purchases  Ledger,  respectively. 
In  the  Sales  Ledger  are  kept  only  the  accounts  with  customers 
i.e.,  the  accounts  receivable.  In  the  Purchases  Ledger  are  kept 
only  the  accounts  with  creditors,  i.e.,  the  accounts  payable.  In 
place  of  the  individual  accounts  receivable  and  payable  in  the 
General  Ledger  there  appear  the  accounts  receivable  and  payable 
controlling  accounts,  which  are  charged  at  the  end  of  each  month 
with  the  total  amount  of  the  detailed  charges  made  to  the  cor- 
responding accounts  in  the  subordinate  ledgers  and  credited 
with  the  total  amount  of  detailed  credits  made  to  the  correspond- 
ing accounts  in  the  subordinate  Ledgers.  In  this  way  the  con- 
trolling accounts  are  charged  and  credited  with  the  same  amounts, 
in  toto,  as  the  subordinate  ledgers  are  charged  and  credited  with, 
in  detail. 

Special  Columns  in  Journals  Illustrated. — To  complete  the 
system  it  is  necessary  to  introduce  special  columns  in  the  General 
and  Cash  Journals  for  the  reception  of  items  representing  charges 
or  credits  to  be  posted  to  the  subordinate  ledgers.  Thus,  since 
cash  receipts  are  entered  on  the  left  hand  page  of  the  Cash  Journal, 
a  column  should  be  provided  there  for  Accounts  Receivable,  and 
since  accounts  paid  are  entered  on  the  right  hand  page  of  the 
Cash  Journal,  a  column  should  be  provided  there  for  Accounts 
Payable.  Sometimes  open  accounts  are  settled  by  note,  draft, 
or  trade  acceptance.  When  this  occurs  entry  must  be  made  in 
the  General  Journal,  and  a  debit  column  should  be  provided 
therein  for  Accounts  Payable  and  a  credit  column  for  Accounts 
Receivable.     These  will  also  be  useful  in  making  adjustments  for 


LEDGERS  AND  CONTROLLING  ACCOUNTS 


109 


returned  purchases  and  returned  sales  when  no  special  journals 
are  provided  for  recording  them.  When  these  special  columns 
are  provided,  the  individual  items  can  be  posted  to  the  proper 
accounts  in  the  subordinate  ledgers,  while  the  totals  of  the  col- 
umns can  be  carried  each  month  to  the  proper  controlling 
accounts.  Forms  of  Cash  and  General  Journals  with  special 
accounts  receivable  and  payable  columns  are  shown  below: 


Cash  Journal,  Marion  Smith  (left  side) 


Date 


Jan. 


Explanation 


18 


A.  L.  Grant 

L.  O.  McDonald . 


Accounts  Rec. 


Accounts  Receivable,  Cr. 
Cash,  Dr.  I       I 


50 
25 

75 


General 


Cash  Journal,  Marion  Smith  (right  side) 


Date 


Explanation 


Accounts  Pay 


General 


Jan. 


Atlas  Company 

Oregon  &  Sons 

Newton  &  Company. 


Accounts  Payable,  Dr. 
Cash,  Cr.  I      I 


200 

150 

98 


448 


00 


General  Journal,  Marion  Smith 

Explanation 

F 

Dr. 
Accts.  Pay 

Dr. 
General 

Cr. 
Accts.    Rec. 

Cr. 
General 

Jan.  10 

Fuller  Supply  Co 

To  Notes  Payable 

Note  due  in  I  mo.,  int.  at 
6%. 

Jan.  20 
Notes  Receivable 

100 
125 

00 
00 

72 

00 

72 

00 

100 
125 

00 
00 

To  O.  O.  Stout 

Due  in  1  mo.,  int.  at  6%. 

Jan.  21 
AtUu  Company 

To  Notes  Payable 

Due  in  1  mo.,  int.  at  6%. 

Accounts  Payable,  Dr.... 
Accounts  Receivable,  Cr. 

225 

00 

72 

«, 

110  ACCOUNTS  IN  THEORY  AND  PRACTICE 

A  variation  in  the  form  of  the  General  Journal  is  shown  below : 
General  Journal,  Marion  Smith 


Accts.  Pay 
Dr. 

General          r. 
Dr.            ^ 

Explanation 

F 

General 
Cr. 

Accts.  Rec. 
Cr. 

Diary    of    Events. — The   specimen   entries   shown   are   the 
following: 

Jan.  1.     Smith  buys  of  Atlas  Company,  mdse.,  $200,  on  account. 
Jan.  2.     Smith  buys  of  Fuller  Supply  Co.,  mdse.,  $100,  on  account. 
Jan.  3.     Smith  sells  to  A.  L.  GrSant,  mdse.,  $50.00,  on  account,  and  to 
L.  O.  McDonald,  $25.00  on  account. 

Jan.  9,     Smith  pays  Atlas  Company,  bill  Jan.  1,  $200.00. 
Jan.  10.     Smith  gives  note,  due  in  one  mo.,  interest  at  6%,  to  Fuller 
Supply  Co.,  in  payment  of  bill  of  Jan.  2,  $100. 
Jan.  11.     Smith  buys  of  Oregon  &  Son,  mdse.,  $150,  on  account. 

Sells  to  O,  O.  Stout,  mdse.,  on  account,  $72.00. 

Buys  mdse.  from  Atlas  Co.,  $125,  on  account. 

Buys  mdse.  of  the  Newton  Co.,  $98,  on  account. 

A.  L.  Grant  pays  account,  $50;  L.  O.  McDonald  pays  account. 


Jan.  12. 
Jan.  16. 
Jan.  17. 
Jan.  18. 
$25.00. 
Jan.  19. 
Jan.  20. 


Pays  Oregon  &  Son,  bill  Jan.  11,  $150,  cash. 

O.  O.  Stout  gives  note  due  in  one  mo.  in  settlement  of  account, 
interest  at  6%. 
Jan.  21.     Pays  Atlas  Co.  bill  of  Jan.  16,  with  note  due  in  1  mo.,  at  6%. 
Jan.  22.     Pays  Newton  &  Co.  bill  of  Jan.  17,  Cash,  $98. 

Postings  Explained. — The  postings  of  the  totals  of  the  details 
in  these  special  columns  are  carried  to  the  subordinate  ledgers. 
Thus  from  the  Sales  Journal  the  individual  accounts  receivable 
are  debited  in  the  subordinate  Accounts  Receivable  Ledger, 
while  the  total  of  sales  is  charged  to  the  Accounts  Receivable 
controlling  account  and  credited  to  the  Sales  account  in  the 
General  Ledger.  From  the  Purchases  Journal  the  individual 
accounts  payable  are  credited  in  the  subordinate  Accounts  Pay- 
able Ledger,  while  the  total  of  purchases  is  charged  to  Purchases 
account  and  credited  to  the  Accounts  Payable  controlling  ac- 
count in  the  General  Ledger.  From  the  left  side  of  the  Cash 
Journal  the  individual  accounts  receivable  are  credited  in  the 
subordinate  Accounts  Receivable  Ledger,  while  the  total  amount 
of  the  accounts  receivable  column  is  posted  to  the  credit  side 
of  the  accounts  receivable  controlling  account  in  the  General 


LEDGERS  AND  CONTROLLING  ACCOUNTS  111 

Ledger.  From  the  right  side  of  the  Cash  Journal  the  individual 
accounts  payable  are  debited  in  the  subordinate  Accounts 
Payable  Ledger,  while  the  total  amount  of  the  accounts  payable 
column  is  posted  to  the  debit  side  of  the  accounts  payable  con- 
trolling account  in  the  General  Ledger.  From  the  accounts 
payable  column  in  the  General  Journal  the  individual  accounts 
payable  in  the  subordinate  Accounts  Payable  Ledger  are  debited, 
while  the  total  of  the  column  is  posted  to  the  debit  side  of  the 
accounts  payable  controlling  account  in  the  General  Ledger. 
From  the  accounts  receivable  column  in  the  General  Journal  the 
individual  accounts  receivable  in  the  subordinate  Accounts 
Receivable  Ledger  are  credited,  while  the  total  of  the  column  is 
posted  to  the  credit  side  of  the  accounts  receivable  controlling 
account  in  the  General  Ledger.  As  a  result  of  these  postings 
the  two  controlling  accounts  appear  thus: 

Accounts  Receivable 

Jan.  31      To  sales 147.00        Jan.  31     By  Cash 75.00 

31     By  Notes  Receiv- 
able      72.00 

Accounts  Payable 

Jan.  31     To  Cash 448 .  00        Jan.  31     By  Purchases ....   673 .  00 

31     To  Notes  Payable  225.00 

As  it  happens,  all  accounts,  both  receivable  and  payable,  are 
settled,  so  that  no  balance  occurs  in  either  controlling  account. 
Likewise,  if  the  subordinate  ledgers  were  shown,  all  individual 
accounts  therein  would  appear  balanced.  Ordinarily  some 
accounts  payable  and  some  accounts  receivable  will  remain 
unpaid,  in  which  case  the  balance  of  the  controlling  account 
should  equal  the  total  of  the  balances  of  the  subordinate  ledger 
which  it  controls.  Thus  if  the  Accounts  Receivable  account  in 
the  General  Ledger  shows  a  balance  of  $227.10,  then  the  total 
of  the  debit  balances  in  the  subordinate  Accounts  Receivable 
Ledger  should  equal  $227.10,  and  so  on. 

Location  of  Errors  Facilitated. — The  specialization  possible 
under  the  principle  of  controlling  accounts  and  subordinate 
ledgers  is  limited  only  by  the  requirements  of  the  business. 
Note  that  the  number  of  accounts  in  the  General  Ledger  is  greatly 
diminished  by  the  removal  of  the  individual  accounts  receivable 
and  payable.  This  facilitates  taking  the  trial  balance  and 
locating  errors.     If,  when  all  postings  have  been  made,  a  sub- 


112  ACCOUNTS  IN   THEORY  AND  PRACTICE 

ordinate  ledger  is  not  in  agreement  with  its  controlling  account, 
the  error  is  thus  localized  and  search  for  it  can  be  made  within 
a  limited  field. 

Notes  Receivable  and  Payable  Journals. — When  the  number 
of  notes  receivable  and  payable  become  large  enough  to  warrant, 
special  journals  should  be  introduced  to  receive  them.  These 
journals  should  be  given  some  such  titles  as  Notes  Receivable 
Journal  and  Notes  Payable  Journal.  It  is  not  customary,  how- 
ever, to  post  these  to  subordinate  ledgers  similarly  named,  as 
is  done  with  accounts  receivable  and  accounts  payable.  This  is 
because  notes  receivable  and  payable  are  usually  given  in  settle- 
ment of  personal  accounts  receivable  and  payable  and  conse- 
quently are  posted  to  the  subordinate  ledgers  which  contain 
these  personal  accounts.  The  journals  serve  as  detailed  records 
of  the  notes.  Since  notes  receivable  are  received  in  satisfaction 
of  accounts  receivable,  postings  from  the  Notes  Receivable 
Journal  will  be  made  in  detail  to  the  Accounts  Receivable  Ledger, 
while  the  total  of  the  Notes  Receivable  entered  for  the  month  is 
posted  to  the  credit  of  the  accounts  receivable  controlHng  ac- 
counts and  to  the  debit  of  the  notes  receivable  account  in  the 
General  Ledger.  Since  notes  payable  are  given  in  payment  of 
accounts  payable,  postings  from  the  Notes  Payable  Journal  will 
be  made  in  detail  to  the  Accounts  Payable  Ledger,  while  the 
total  of  the  notes  payable  entered  for  the  month  is  posted  to  the 
debit  of  the  accounts  payable  controlling  account  and  to  the 
credit  of  the  notes  payable  account  in  the  General  Ledger. 

Returned  Sales  and  Purchases. — When  the  returned  sales  and 
purchases  are  not  numerous  they  may  be  recorded  in  the  General 
Journal,  either  by  providing  special  columns  for  their  reception, 
or  by  entering  them  in  the  general  or  sundries  column  and  posting 
them  individually  to  "returned  sales"  and  "returned  purchases" 
accounts  in  the  General  Ledger.  If,  however,  either  or  both  of 
these  classes  of  transactions  become  numerous,  it  is  then  neces- 
sary to  provide  special  journals  for  them.  These  are  known 
respectively,  as  the  Returned  Sales  Journal  and  the  Returned 
Purchases  Journal.  They  differ  in  no  way  from  the  ordinary 
form  of  journal.  In  the  Returned  Sales  Journal  the  name  of  the 
party  credited  is  entered  in  the  explanation  column,  and  the 
amount  of  his  credit  is  posted  to  the  credit  of  his  account  in  the 
Accounts  Receivable  Ledger.  At  the  end  of  the  month  the 
total  of  the  returned  sales  is  posted  to  the  debit  of  the  "returned 


LEDGERS  AND  CONTROLLING  ACCOUNTS  113 

sales"  account  and  to  the  credit  of  the  "accounts  receivable" 
controlling  account  in  the  General  Ledger. 

In  the  Returned  Purchases  Journal  the  name  of  the  party 
charged  is  likewise  entered  in  the  explanation  column  and  the 
amount  is  posted  to  the  debit  side  of  his  account  in  the  Purchases 
Ledger.  At  the  month's  end  the  total  of  returned  purchases  is 
posted  to  two  accounts  in  the  General  Ledger — to  the  debit  of 
the  Accounts  Payable  controlling  account  and  to  the  credit  of 
the  Returned  Purchases  account. 

Note. — At  this  point  work  should  be  started  or  the  practical 
exercises  given  in  Chapter  XVIII  and  pursued  together  with  the 
study  of  Chapter  XVI I. 


CHAPTER  XVII 
ACCOUNTING  FOR  PETTY  CASH  PAYMENTS 

The  Bank  Account. — A  problem  which  arises  in  the  daily 
routine  of  business  consists  in  efficiently  paying  out  small  sums 
of  cash.  It  is  customary  for  nearly  every  proprietor,  firm,  and 
company  to  keep  an  account  at  one  or  more  banks.  Banks 
furnish  many  conveniences.  It  is  through  them  that  the  plan 
of  making  payment  by  means  of  checks  becomes  possible.  Banks 
possess  facilities  for  collection,  credit  granting,  etc.,  which  make 
them  indispensable  aids  in  modern  business.  An  account  is 
opened  at  a  bank  by  making  an  initial  deposit  of  money  for 
which  the  depositor  receives  a  receipt  in  the  form  of  a  pass  book 
with  the  amount  of  the  deposit  inserted.  He  also  receives  a 
check  book  which  contains  blank  checks.  These  he  fills  out 
and  signs  when  making  a  payment  by  check. 

Petty  Cash  Disbursements. — Checks  are  the  best  medium  of 
payment  for  all  except  relatively  small  sums.  These  small 
payments  are  usually  best  made  in  coin,  and  in  order  to  secure 
an  adequate  supervision  and  control  over  such  disbursements 
the  imprest  system  of  handling  petty  cash  has  been  widely 
adopted.  A  little  reflection  will  show  that  if  all  cash  receipts 
are  entered  in  the  Cash  Journal  and  also  deposited  in  the  bank, 
and  that  if  all  cash  payments  are  entered  in  the  Cash  Journal  and 
drawn  out  of  the  bank  by  check,  then  the  balance  of  the  Cash 
Journal  should  agree  with  the  balance  of  the  check  book,  and 
also  with  the  balance  shown  by  the  bank  pass  book,  or  report, 
outstanding  checks  being  taken  into  consideration.  It  would 
be  a  simple  procedure  to  deposit  the  total  receipts  of  each  day 
on  the  day  following  were  it  not  for  the  fact  that  certain  small 
cash  disbursements  (not  by  check)  are  being  made  continually. 
When  these  petty  disbursements  of  cash  are  being  made  out  of 
the  cash  receipts  for  the  day,  the  full  amount  of  the  cash  receipts 
cannot  be  deposited  on  the  following  day.  As  a  consequence, 
the  day's  receipts,  as  shown  by  the  Cash  Journal,  do  not  corre- 
spond in  amount  with  the  deposit  for  that  day.     Moreover,  the 

114 


ACCOUNTING  FOR  PETTY  CASH  PAYMENTS  115 

cash  payments,  as  shown  by  the  right  side  of  the  Cash  Journal, 
are  in  excess  of  the  checks  drawn  by  the  amount  of  the  disburse- 
ments made  directly  from  the  cash  drawer. 

The  Imprest  System. — This  leads  to  confusion  and  makes 
it  difficult  to  explain  discrepancies  which  arise  between  the 
Cash  Journal  on  the  one  hand  and  the  check  book  and  pass 
book  on  the  other.  ^  This  trouble  may  be  avoided  by  drawing 
a  check,  to  "cash,"  upon  the  bank  for  a  sum  sufficient  to  make 
all  petty  cash  payments  for  a  given  period — a  week,  or  possibly 
two  weeks.  In  the  Cash  Journal  this  check  should  be  charged 
to  "petty  cash,"  thus: 

Petty  Cash 

To  Cash 


The  amount  thus  drawn  is  called  the  petty  cash  fund,  and  from  it 
all  disbursements  other  than  those  by  check  should  be  made. 
These  small  disbursements  of  cash  should  not  be  entered  directly 
in  the  Cash  Journal,  but  a  specially  ruled  book  known  as  the 
Petty  Cash  Book  should  be  provided.  The  Petty  Cash  Book 
should  contain  as  many  columns  as  are  needed  in  order  to  charge 
each  disbursement  to  the  proper  account.  Blank  columns  should 
also  be  provided  for  the  reception  of  more  unusual  charges,  or  at 
least  a  "miscellaneous"  column  should  be  provided.  If  expense 
accounts  are  kept  in  the  General  Ledger  for  Stationery  and  Print- 
ing, General  Expense,  Telegrams,  Withdrawals  (proprietor's), 
Purchases,  and  Advertising,  charges  to  which  accounts  frequently 
result  from  the  direct  disbursement  of  cash,  in  addition  to 
those  made  by  check,  then  the  following  ruling  shows  a  suitable 
form  of  Petty  Cash  Book  (page  116). 

Suppose  that  $100  is  sufficient  to  make  all  petty  cash  disburse- 
ments for  one  week,  and  that  sum  is  drawn  by  check  as  suggested 
above.  When  this  is  posted  to  the  Ledger  an  account  is  opened 
for  petty  cash,  thus: 

Petty  Cash 

Jan.  1.     To  Cash $100.00 

From  the  petty  cash  fund  the  following  disbursements  are  made 
during  the  week  and  entered  in  the  Petty  Cash  Book,  as  shown 
above : 

"  The  pass  book  is  being  displaced  by  the  monthly  statement,  which  lists 
checks  drawn  and  deposits  made. 


116 


ACCOUNTS  IN   THEORY  AND  PRACTICE 


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ACCOUNTING  FOR  PETTY  CASH  PAYMENTS  117 

June  1.  Stationery   and   printing,    $2.20;   telegrams,    $3.00;   purchases, 
$10.00. 

2.  Withdrawals,  $5.00;  advertising,  $3.00;  purchases,  $5.00. 

3.  Purchases,  $10.20. 

5.  General  expense,  $0.10;  interest,  $10.00. 

6.  Withdrawals,  $5.00;  general  expense,  $2.60;  purchases,  $12.00. 

7.  General  expense,    $1.00;  telegrams,   $4.00;  advertising,   $1.00; 
purchases,  $15.00. 

At  the  end  of  the  week  the  total  of  each  column  shows  how 
much  has  been  disbursed  for  each  account,  while  the  total  petty 
cash  disbursements  represent  the  amount  paid  out  of  the  petty 
cash  fund.  This  total  is  found  by  listing  the  totals  of  the  special 
columns  and  any  items  that  may  appear  in  the  miscellaneous 
column,  thus: 

Stationery  and  Printing $  2 .  20 

General  Expense 3 .  60 

Telegrams 7 .00 

Withdrawals 10.00 

Purchases 52.20 

Advertising 4 .  00 

Interest 10. 00 

Total $89.00 

Consequently  there  should  remain  $11  in  the  petty  cash  fund. 
It  is  next  in  order  to  replenish  the  petty  cash  fund  by  drawing  a 
check  for  $89,  at  the  same  time  charging,  in  the  Cash  Journal, 
the  various  accounts  for  which  the  money  was  paid  out. 

Whether  any  particular  account  ought  to  be  paid  by  check 
or  out  of  petty  cash  is  a  matter  of  convenience.  Usually  the 
question  must  be  decided  by  the  amount — if  large,  the  check  is 
better;  if  small,  direct  cash  payment  may  be  better.  Every  petty 
cash  disbursement  should  be  receipted  for  to  prevent  the  possi- 
bility of  improper  withdrawals  from  the  petty  cash  fund. 

Advantages  of  Imprest  System.— The  petty  cash  fund  s  ould 
be  kept  separate  from  the  daily  cash  receipts.  Its  introduction 
makes  it  easy  to  deposit  as  one  sum  the  total  of  the  day's  receipts. 
The  amount  of  such  deposit  is  also  entered  in  the  check  book  and 
in  the  bank  pass  book,  thus  making  uniform  the  record  of  re- 
ceipts in  Cash  Journal,  check  book,  and  pass  book.  Moreover, 
all  disbursements  are  made  either  directly  or  indirectly  by  check, 


118  ACCOUNTS  IN  THEORY  AND  PRACTICE 

since  the  petty  cash  fund  is  replenished  only  by  drawing  a  check 
for  the  amount  of  the  petty  cash  disbursements.  Hence  the 
disbursements  side  of  the  Cash  Journal  should  also  be  in  agree- 
ment with  the  check  book  and  bank  statement,  when  outstanding 
checks  are  considered.  Correct  accounting  for  cash  is  greatly 
simplified  through  the  use  of  the  imprest  system. 


CHAPTER  XVIII 

CONTROLLING    ACCOUNTS    AND     IMPREST    SYSTEM 

PRACTICE 

Diary  of  Events. — A.  J.  Allen  and  R.  T.  Goodloe,  partners 
engaged  in  the  general  retail  business,  decide  to  open  new  books 
as  of  Jan.  1,  1919  Previously  to  this  hey  have  kept  a  General 
Journal,  Cash  Journal  and  Ledger,  and  small  cash  disbursements 
have  been  made  from  cash  on  hand,  no  attempt  being  made  to 
deposit  all  receipts  in  bank.  The  constantly  increasing  number 
of  customers  and  creditors  has  filled  the  Ledger  with  a  large 
number  of  accounts,  making  it  difficult  to  take  a  trial  balance 
and  to  subdivide  the  clerical  work  among  the  office  force. 

Having  consulted  public  accountants,  Allen  and  Goodloe  decide 
to  install  a  new  system  of  accounts  requiring  the  use  of  the 
following  books : 


1. 

Cash  Journal. 

5. 

Accounts  Payable  Ledger. 

2. 

General  Journal. 

6. 

Petty  Cash  Book. 

3. 

Sales  Journal. 

7. 

Returned  Sales  Journal. 

3a. 

Purchases  Journal. 

8. 

Returned  Purchases  Journal 

4. 

Accounts  Receivable  Ledger. 

9. 

General  Ledger. 

After  closing  the  old  books  the  accountants  make  an  analysis 
of  the  accounts  and  submit  the  following  balance  sheet  of  Allen 
and  Goodloe: 


Balance  Sheet,  Allen  and  Goodloe,  as  at  January  1,  1919 : 

Assets  Liabilities  and  Capital 

Buildings  and  Land $22,500         Capital— A.  J.  Allen $15,500 

Inventory  1/1/19 10,310  Capital— R.  T.  Goodloe. .       14,300 

Accounts    Receivable  Accounts  Payable  (Sohed- 

(Schedule  I) 4,312  ulell)..... 3,317 

Insurance  Prepaid  200  Mortgage  on  Buildings  . . .        9,055 

Furniture  and  Fixtures  . .  900 

Notes  Receivable 500 

Cash 3,200 

Salaries  Prepaid  250 

$42,172  $42,172 

119 


120  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Schedule  I 

List  of  Accounts  Receivable,  Allen  and  Goodloe,  as  at  January  1,  1919: 

J.  M.  Ogden $  217.40 

L.  B.  Brewer 100.00 

S.  K.  Cortland 27. 12 

O.  D,  Dunn 328.05 

R.  R.  Rutherford 10.40 

A.  K.  Cornwall 813.50 

The  Wildwood  Club 1,400.00 

N.  N.  Smith 310.00 

B.  A.  Barton 43 .  10 

L.  D.  Donovan 77 .  11 

A.  A.  Alden 350.50 

G.J.  Winters 43.70 

M.  S.  Gates 15.70 

K.  N.  Brown 11.75 

D.  F.  Swift 73. 10 

L.  O.  Dent 112.00 

S.  S.  Sutherland 200.00 

J.J.  Oliver 3.12 

S.  K.  Cousin 175.45 

Total  Accounts  Receivable $4,312.00 

Schedule  II 
List  of  Accounts  Payable,  Allen  and  Goodloe,  as  at  January  \,  1919: 

Burton  and  Fitch $  213.00 

Clyde  Manufacturing  Co 275 .  40 

Wholesale  Grocery  Co 635 .  00 

Atkins  and  Jones 127.00 

L.  O.  March 23.00 

Johnson  and  Company 378 .  60 

S.  Sisson  &  Sons .  380.00 

Allen  and  Allen 320.00 

S.  Tompkins  &  Sons 140.00 

J.  Loomis 600.00 

Gordon  and  Smith 225.00 

Total  Accounts  Payable $3,317.00 

Note. — These  schedules  contain  fewer  accounts  than  would 
originally  be  found  in  practice.  The  number  is  purposely 
limited  to  avoid  bringing  unnecessary  details  into  the  problem. 

We  must  now  determine  the  form  and  arrangement  of  the 
required  books.  The  General  Ledger  and  the  Accounts  Re- 
ceivable and  Accounts  Payable  Ledgers  should  contain  twelve 
pages  each  of  ordinary  ledger  paper.  For  the  Sales  Journal, 
Returned  Sales  Journal,  Purchases  Journal,  and  Returned  Pur- 
chases Journal  use  ordinary  journal  paper,  one  single  sheet  for 


CONTROLDING  ACCOUNTS  121 

each.  Page  these  books  and  head  the  money  columns  of  each  of 
the  four  journals  "Extensions"  and  "Totals,"  respectively. 
Write  in  the  title  of  each  book,  "General  Ledger,"  "Sales 
Journal,"  and  so  on. 

Make  the  Cash  Journal  from  a  double  sheet  of  four  column 
journal  paper,  heading  the  columns  on  the  left  side,  respectively, 
'Accounts  Receivable,"  "Discount  on  Sales,"  "Sundries," 
and  "Net."  Head  the  columns  on  the  right  side  "Accounts 
Payable,"  "Discount  on  Purchases,"  "Sundries"  and  "Net." 
The  form  is  shown  below  (page  122). 

Note. — ^The  columns  in  the  Petty  Cash  Book  should  be  such 
as  are  found  by  experience  to  be  necessary;  that  is,  they  are  for 
such  accounts  as  receive  charges  most  frequently  from  small 
cash  payments  where  checks  are  not  used.  The  more  unusual 
items  can  be  cared  for  in  the  "Sundries"  column. 

To  construct  the  General  Journal  use  a  sheet  of  six-column 
journal  paper  and  head  the  first  three,  or  debit,  columns,  respec- 
tively, "Accounts  Payable,"  "Notes  Receivable,"  and  Sundries," 
and  the  last  three,  or  credit,  columns,  respectively,  "Accounts 
Receivable  "  "Notes  Payable,"  and  "Sundries." 

Next  open  this  new  set  of  books  with  an  entry  in  the  General 
Journal  charging  the  assets  invested  and  crediting  liabilities 
and  the  partners'  capital  accounts.  Enter  the  debits  (as  listed 
in  the  balance  sheet)  in  the  'Sundries"  debit  column  and  the 
credits  (as  hsted  in  the  balance  sheet)  in  the  "Sundries"  credit 
column  in  the  General  Journal.  Check  Cash  (\/)  in  the  General 
Journal  and  enter  it  in  the  Cash  Journal,  writing  "Balance" 
in  the  explanation  column  and  placing  the  amount  in  the  "Net" 
column.  Post  these  (except  Cash,  which  will  be  posted  from 
the  Cash  Journal)  to  the  General  Ledger  opening  accounts 
therein  as  follows: 

Capital — A.  J.  Allen page  1,  top 

Capital — R.  T.  Goodloe page  1,  middle 

Buildings page  2,  top 

Inventory page  2,  middle 

Insurance  Prepaid page  3,  top 

Furniture  and  Fixtures page  3,  middle 

Notes  Receivable page  4,  top 

Cash page  4,  middle 

Salaries  Prepaid page  5,  top 

Accounts  Payable page  6,  top 

Accounts  Receivable page  6,  middle 

Mortgage  on  Buildings page  7,  top 


122 


ACCOUNTS  IN   THEORY  AND  PRACTICE 


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CONTROLLING  ACCOUNTS  123 

As  occasion  arises  additional  accounts  should  be  opened 
where  convenient  in  the  General  Ledger.  Next  enter  the  in- 
dividual accounts  receivable  and  the  individual  accounts  pay- 
able in  the  Accounts  Receivable  Ledger  and  the  Accounts 
Payable  Ledger,  respectively,  two  to  a  page,  and  in  the  order 
given  in  Schedules  I  and  II.  In  the  explanation  column  in 
these  ledgers  write,  for  each  account,  the  word  "Balance," 
together  with  the  date. 

Diary  of  Events,  Allen  and  Goodloe,  January,  1919 

Jan.  1.  Establish  a  Petty  Cash  fund  of  $100.  Pay  the  Daily  News  Co. 
with  check,  $10.00,  for  current  advertising.  Sell  on  account  to  B.  A. 
Barton,  mdse.,  $15.20  and  to  G.  J.  Winters  $61.75.  Pay  from  petty  cash 
$0.75  for  a  telegram  (charge  General  Expense)  and  $1 .  20  for  stationery. 

Note. — Enter  the  charge  for  advertising  in  the  Cash  Journal, 

charging    "Advertising,"    and    entering    the    amount    in    the 

"Sundries"  column.     Enter  the  sale  to  B.  A.  Barton  in  the 

Sales  Journal,    putting  the  amount  in  the  "Totals"  column. 

This  entry  differs  from  an  entry  in  the  General  Journal  in  that 

but  one  line  is  required  for  the  entry  proper,  thus: 

Totals 

B.  A.  Barton $15.20 

Also  make  the  entry  for  G.  J.  Winters.  Before  making  the 
payment  from  petty  cash  it  is  necessary  to  estabhsh  a  petty 
cash  fund.  This  is  done  by  drawing  a  check  for  the  required 
amount,  here  100.,  cashing  it,  and  keeping  the  fund  on  hand  for 
all  disbursements  not  made  by  check.  Charge  "Petty  Cash" 
in  Cash  Journal,  entering  the  amount  in  the  "Sundries"  column. 
Next  enter  the  payment  from  petty  cash  in  the  Petty  Cash 
Book  under  the  date  of  "Jan  1,"  placing  the  total  ($1.95)  in  the 
"Amount"  column  and  making  the  distributions,  "General 
Expense,"  $0.75,  and  "Stationery  &  Printing,"  $1.20. 

Jan.  2.  Pay  Johnson  &  Co.  in  full  of  account,  $378.60,  taking  a  discount 
on  that  amount  of  2% 

Enter  this  in  the  Cash  Journal,  charging  Johnson  &  Co., 
with  $378.60  in  the  "Accounts  Payable"  column,  entering  the 
d  scount  in  the,  "Discount  on  Purchases"  column,  and  the 
net  amount  paid  in  the  "Net"  column. 

Jan.  3.  Sell  on  account  to  O.  D.  Dunn,  $120.15,  and  to  L.  O.  Donovan, 
$62.30.  G.  J.  Winters  pays  account  in  full.  Petty  cash  payments  for 
General  Expense,  $8.40. 


124  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Jan.  4.  Pay  Atkins  and  Jones  in  full  of  account,  taking  the  discount  of  1  %. 

Jan.  6.  Pay  the  Wholesale  Grocery  Co.  in  full  of  account,  taking  the  dis- 
count of  2%. 

Jan.  7.  Cash  sales  for  week  $920.16.  Purchase  from  the  Wholesale 
Grocery  Co.  mdse.,  $147.30,  2%,  10  days,  net  30.  Petty  cash  disburse- 
ments: purchases,  $11.40;  advertising,  $8.30;  general  expense,  $5.12.  '  Sell 
on  account  to  J.  M.  Ogden,  $19.00;  to  K.  N.  Brown,  $50.00;  to  A.  A.  Alden, 
$10.40.     The  Wildwood  Club  and  A.  A.  Alden  pay  in  full  to  date. 

Note. — Enter  cash  sales  in  the  "Net"  column  of  the  Cash 
Journal.  Enter  the  purchase  from  the  Wholesale  Grocery  Co. 
in  the  Purchases  Journal,  "Totals"  column,  ndicating  terms 
in  the  "Explanation'  column,  thus; 

Totals 
Wholesa  e  Grocery  Co.,  2/10,  n/30 -.   $147.30 

Jan.  8.  Purchase  from  Allen  and  Allen  show  case,  $50.00  net,  and  mdse., 
$100,  terms  2/10,  net  30. 

Note. — It  is  necessary  to  make  two  entries  for  this  purchase. 
Enter  the  purchase  of  $100,  mdse.,  in  the  Purchases  Journal,  and 
the  purchase  of  show  case  in  the  General  Journal,  charging  Furni- 
ture and  Fixtures  in  the  debit  "Sundries"  column  and  crediting 
Allen  and  Allen  in  the  credit  "Sundries"  column.  In  posting 
this  credit  to  Allen  and  Allen  carry  it  to  both  the  credit  side  of 
the  Allen  and  Allen  account  in  the  Accounts  Payable  Ledger  and 
to  the  credit  side  of  the  Accounts  Payable  controlling  account  in 
the  General  Ledger.  This  is  an  unusual  procedure  and  if  many 
items  of  purchases  other  than  mdse.  occurred  it  would  be  desir- 
able to  supply  one  or  more  special  columns  in  the  Purchases 
Journal  for  purchases  other  than  mdse.  Another  plan  would 
be  to  provide  an  "Accounts  Payable"  credit  column  in  the  Gen- 
eral Journal. 

Jan.  9.  Pay  Burton  &  Fitch  $213  in  full  of  account;  also  Clyde  Manufac- 
turing Co.  $275.40.  Petty  Cash  payments:  purchases  $11.40;  general 
expense,  $6.37. 

Jan.  13.  Purchase  from  Gordon  &  Smith,  mdse.,  $110.00,  net  15  days. 
Pay  Gordon  &  Smith  bill  of  $225.00,  net. 

Jan.  14.  Purchase  from  J.  Loomis,  furniture  for  store,  $75.00  net  15  days. 
Sell  on  account  to  R.  R.  Rutherford,  mdse.;  $115.00.  Pay  help  for  2  weeks, 
$350.00.  Draw  check  for  amount  of  petty  cash  disbursements  charging 
proper  account  in  Cash  Journal.     Cash  sales  for  week,  $872.41. 

Note. — Enter  purchases  of  furniture  similarly  to  that  made  on 
Jan.  8. 


CONTROLLING  ACCOUNTS  125 

Jan.  15.  Mr.  Allen  withdraws  $5  from  petty  cash  for  personal  use.  Sell 
mdse.  Ota.  ^count  to  N.  N.  Smith,  $38.20. 

Jan.  16.  Pay  Wholesale  Grocery  Co.  bill  of  Jan.  7,  $147.30,  less  discount. 
Petty  cash  disbursements:  general  expense,  $14.60;  purchases,  $18.92. 

Jan.  17.  Pay  Allen  and  Allen  bill  of  Jan.  8,  $148  net. 

Jan.  18.  R.  R.  Rutherford  returns  goods,  receiving  credit,  $10.20.  A.  K. 
Cornwall  pays  account  in  full,  $813.50. 

Note. — Enter  the  returned  sales  transaction  in  the  Returned 
Sales  Journal,  writing  "A.  K.  Cornwall"  in  the  explanation 
column,  and  placing  the  amount  in  the  "Totals"  column.  Post 
to  credit  of  Cornwall's  account. 

Jan.  20.  Petty  cash  payments:  R.  T.  Goodloe,  withdrawals,  $11.00; 
purchases  $8.40;  general  expense  $5.10.  Pay  L.  O.  March,  $23.00;  also  S. 
Tompkins  &  Son,  $140.00. 

•^Jan.  21.  Cash  sales  for  week,  $1315.42.     Pay  Gordon  &  Smith  $110.00 
net. 

Jan.  22.  B.  A.  Barton  returns  goods,  $5.00. 

Jan.  23.  Purchase  mdse.  from  Wholesale  Grocery  Co.,  2/10,  net  30, 
$127.00. 

Jan.  24.  Return  mdse.  purchased  to  Wholesale  Grocery  Co.,  $55,  and 
to  S.  Sisson  and  Sons,  $25.50.  Petty  cash  payments:  general  expense,  $2.13; 
purchases,  $18.00. 

Jan.  25.  Sell  on  account  to  Wildwood  Club,  $40. 

Jan.  27.  Pay  J.  Loomis  bill  of  $75  net. 

Jan.  28.  R.  R.  Rutherford  pays  account  in  full,  $115.20. 

Jan.  31.  O.  D.  Dunn  gives  note  due  in  2  mo.  int.  at  6%  in  payment  in 
full  of  his  account.  Pay  help,  $378.00.  Cash  sales  since  Jan.  21,  $1140. 
Draw  check  to  replenish  petty  cash,  making  proper  entry.  Purchase 
adjoining  building  from  A.  A.  Smith  for  $4000,  paying  $1000  cash  and  giving 
note  due  in  6  mo.  for  balance,  $3000. 

Take  a  trial  balance,  make  adjustment  and  closing  entries 
and  set  up  profit  and  loss  account  and  balance  sheet.  Interest 
on  the  mortgage  is  at  6%  payable  semi-annually,  June  30  and 
Dec.  31.  Make  entry  for  accrued  interest  on  mortgage  in  the 
General  Journal.     The  inventory  as  at  Jan.  31  is  $8,000. 


CHAPTER  XIX 
THE  VOUCHER  REGISTER 

The  Voucher  Register  is  an  evolution  of  the  Purchases  Journal 
brought  about  by  the  suggestion  that  the  Purchases  Journal 
might  be  made  to  serve  the  purpose  of  both  the  Purchases  Journal 
and  the  Accounts  Payable  Ledger.  It  is  a  book  provided  with 
columns  for  the  creditors'  names  and  for  the  proper  distribution 
of  the  charge  or  purchase.  There  is  an  endless  variety  of  forms 
of  the  Voucher  Register,  of  which  the  following  is  one  illustration 
(page  127). 

The  Voucher  System. — With  the  Voucher  Register  it  is  cus- 
tomary to  inaugurate  a  more  or  less  comprehensive  system  of 
vouchers.  Vouchers  are  documents  printed  uniformly  in  pads, 
numbered  consecutively,  and  so  arranged  that  the  distribution 
of  charges  on  one  or  more  invoices  (as  many  as  it  may  be  desirable 
to  pay  with  one  check)  can  be  indicated  thereon.  Before  an 
invoice  is  vouchered  it  should  be  checked  up  with  the  goods 
received.  If  the  goods  are  as  invoiced,  it  is  authorized  for 
payment,  the  voucher  is  attached  to  it,  and  the  charge  distributed 
properly  thereon.^  It  now  becomes  a  voucher  payable  and  an 
entry  should  be  made  in  the  Voucher  Register,  the  chaiges  being 
distributed  in  the  proper  columns.  As  many  columns  may  be 
provided  for  the  distribution  of  the  charges  as  may  be  desirable. 
In  the  Voucher  Register  shown  above  there  are  but  two  distribu- 
tion columns.  These  might  be  expanded  to  ten,  or  more,  if 
necessary.  If  there  is  a  charge  for  which  no  special  column  is 
provided,  it  must  be  entered  in  the  "sundries"  column.  The 
number  of  the  voucher  is  entered  in  the  column  headed  "No.," 
and  the  facts  with  reference  to  the  invoice  are  entered  in  the 
columns  headed  "Invoice."  The  amount  of  the  voucher  is 
entered  in  the  "Vouchers  Payable"  column,  the  total  of  which 

'  Sometimes  the  invoice  is  not  sent  to  the  receiving  department  to  be 
checked  up  with  goods  received.  Instead,  a  duplicate  of  the  purchasing 
order,  with  the  items  omitted,  is  sent  to  the  receiving  department  to  be 
filled  in  by  the  receiving  clerk.  This  is  then  compared  with  the  invoice.  In 
this  way  carelessness  in  checking  the  invoice  is  prevented. 

126 


THE  VOUCHER  REGISTER 


127 


is  posted  monthly  to  the  credit  of 
the  vouchers  payable  account  in  the 
General  Ledger.  This  account  takes 
the  place  of  the  accounts  payable 
controlling  account. 

The  voucher  with  invoice  attached 
is  now  filed  in  an  Unpaid  Vouchers' 
File,  where  the  arrangement  may  be 
made  alphabetically,  or  according  to 
time  of  payment.  When  a  check  is 
issued  in  payment  of  the  voucher  note 
to  that  effect  is  entered  in  the  column 
headed  "Check  No.,"  by  inserting 
the  number  of  the  check.  The 
voucher  is  then  filed  in  a  Paid 
Vouchers  file  which  is  frequently  in- 
dexed by  a  card  index  system  to 
facilitate  the  location  of  all  vouchers 
appHcable  to  any  account.  The  two 
voucher  files  then  correspond  to  the 
Accounts  Payable  Ledger,  the  amount 
of  the  unpaid  vouchers  being  equal  to 
the  credit  balance  of  the  Vouchers 
Payable  account  in  the  General 
Ledger  after  all  entries  are  posted. 
The  Cash  Journal  should  contain 
a  Vouchers  Payable  column  from 
which  the  total  should  be  charged  to 
the  Vouchers  Payable  account  at  the 
end  of  the  month.  In  the  General 
Ledger  the  Vouchers  Payable  account 
takes  the  place  of  the  Accounts  Pay- 
able account. 

When  the  check  is  mailed  in  pay- 
ment of  a  voucher  the  invoice  may 
be  sent  with  it  for  the  purpose  of 
having  it  receipted.  The  chief  ob- 
jection to  this  procedure  is  that  the 
invoice  may  not  be  promptly  re- 
turned, or  possibly  not  at  all.  For 
this   reason  the  check  is  sometimes 


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128  ACCOUNTS  IN  THEORY  AND  PRACTICE 

sent  without  the  invoice  and  when  returned  through  the  bank 
it  is  attached  to  the  voucher  and  invoice.  Ordinarily  this  will 
afford  a  sufficient  receipt.  The  demand  for  a  more  specific  and 
definite  receipt  in  the  form  of  an  endorsed  check  has  led  to  the 
adoption  of  the  voucher  check.  Essentially  a  voucher  check 
(Consists  of  an  ordinary  check  form  with  the  addition  of  a  space 
for  an  itemized  statement  of  the  charge  for  whiqh  payment  is 
made.  When  such  a  voucher  check  is  cashed  it  automatically 
becomes  a  receipt.  When  returned  it  may  be  filed  with  the 
invoice  for  which  it  was  issued  in  payment. 

The  voucher  system  may  be  employed  to  handle  only  the 
ordinary  liabilities  that  arise  from  the  purchase  of  merchandise, 
or  it  may  be  made  more  inclusive  so  that  the  Voucher  Register 
becomes  the  medium  or  making  practically  all  charges,  other 
than  adjustments,  including  wages,  expense,  and  all  other 
charges  involving  the  incurrence  of  expense  or  liabilities. 


CHAPTER  XX 
THE  VOUCHER  REGISTER— PRACTICE 

The  exercise  given  in  Chapter  XVIII  is  repeated  in  the  follow- 
ing pages  to  show  the  variations  necessary  when  the  Voucher 
Register  is  employed.  The  transactions  are  identical,  with  only 
some  changes  in  the  wording  of  the  diary  of  events. 

Diary  of  Events. — A.  J.  Allen  and  R.  T.  Goodloe,  partners 
engaged  in  the  general  retail  business,  decide  to  open  new  books 
as  of  January  1,  1919.  Previously  to  this  they  have  kept  a 
General  Journal,  Cash  Journal,  and  Ledger,  and  small  cash 
disbursements  have  been  made  from  cash  on  hand,  no  attempt 
being  made  to  deposit  all  receipts  in  bank.  The  constantly 
increasing  number  of  customers  and  creditors  has  filled  the 
Ledger  with  a  large  number  of  accounts,  making  it  difficult  to 
take  a  trial  balance  and  to  divide  the  work  of  keeping  the  accounts 
among  the  office  force. 

Having  consulted  public  accountants,  Allen  and  Goodloe 
decide  to  install  a  new  system  of  accounts  to  consist  of  the  follow- 
ing books: 

1.  Cash  Journal.  5.  Voucher  Register. 

2.  General  Journal.  6.  Petty  Cash  Book. 

3.  Sales  Journal.  7.  Returned  Salci-  Journal. 

4.  Accounts  Receivable  Ledger.  8.  General  Ledger. 

After  closing  the  old  books  the  accountants  make  an  analysis 
of ^ the  accounts  and  submit  the  following  balaice  sheet  of  Allen 
and  Goodloe: 

Balance  Sheet,  Allen  and  Goodloe,  as  at  January  1,  1919 : 

Assets  Liabililits  and  Capital 

Buildings  and  Land . .        $22,500 .  00  Capital— A.  J.  Allen $15,500 .  00 

Inventory,  1/1/19 10,310.00  Capital— R.  T.  Goodloe.       14,300.00 


Accounts  Receiv-  Vouchers   Payable 

able  (Schedule  I). .. .         4,312.00      (Schedule  II) 3,317.00 

Insurance  Prepaid 200.00  Mortgage  on  Buildings         9,055.00 

Furniture  and  Fixtures  900 .  00 

Notes  Receivable 500.00 

Cash 3,200.00 

Salaries  Prepaid 250. 00 

$42,172.00  $42, 172  00 

9  129 


130 


ACCOUNTS  IN  THEORY  AND  PRACTICE 


Schedule  I 

Ltste  of  Accounts  Receivable,  Allen  and  Goodloe,  as  at  January  1,  1919: 

Name  Amount 

J.  M.  Odgen $  217.40 

L.  B.  Brewer 100.00 

S.  K.  Cortland 27. 12 

O.  D.  Dunn 328.05 

R.  R.  Rutherford 10.40 

A.  K.  Cornwall 813.50 

The  Wildwood  Club 1400.00 

N.  N.  Smith 310.00 

B.  A.  Burton  43. 10 

L.  D.  Donovan 77 .  11 

A.  A.  Alden 350.50 

G.  J.  Winters 43.70 

M.  S.  Gates 15.70 

K.  N.  Brown 11.75 

D.  F.  Swift 73. 10 

L.  O.  Dent 112.00 

S.  S.  Sutherland ; 200.00 

J.  J.  Oliver 3.12 

S.  K.  Cousin 175.45 

Total  Accounts  Receivable $4312.00 


Schedule  II 

List  of  Vouchers  Payable,  Allen  and  Goodloe,  as  at  January 

Name  Terms  Amount  (net) 

Burton  &  Fitch net  $213.00 

The  Clyde  Manufacturing  Co.                 net  275.40 

Wholesale  Grocery  Co 2%  off  to  and  in- 
cluding Jan.  7 

Atkins  &  Jones 1%  off  to  and  in-  622.30 

eluding  Jan.  5  125.73 

L.O.March net  23.00 

Johnson  and  Company 2%  off  to  and  in- 
cluding Jan.  2  371.03 

S.  Sisson  &  Sons net  380.00 

Allen  &  Allen net  320 .  00 

S.  Tompkins  &  Son net  140.00 

J.  Loomis net  600 .  00 

Gordon  &  Smith net  225.00 


1,  1919: 

Discount 

none 
none 

$2.70 

1.27 
none 

7.57 
none 
none 
none 
none 
none 


Total  Vouchers  Payable. 


$3295.46 


Note. — These  schedules  contain  fewer  accounts  than  would 
ordinarily  be  the  case  in  practice.  The  number  is  purposely 
limited  to  avoid  bringing  unnecessary  details  into  the  problem. 


THE  VOUCHER  REGISTER— PRACTICE 


131 


The  term  Vouchers  Payable  is  used  in  anticipation  of  the 
opening  of  the  new  books.  In  reahty  the  Accounts  Payable  do 
not  become  Vouchers  Payable  until  put  through  the  routine 
required  by  the  voucher  system. 

The  next  step  is  to  contrive  the  form  and  arrangement  of  the 
required  books.  The  General  Ledger  and  the  Accounts  Receiv- 
able Ledger  should  contain  twelve  pages  each,  of  ordinary  ledger 
paper.  For  the  Sales  Journal  and  the  Returned  Sales  Journal 
use  ordinary  journal  paper,  one  single  sheet  for  each.  Page 
these  books  and  in  the  Sales  Journal  write  "Extensions"  and 
"Totals"  at  the  head  of  the  first  and  second  money  columns, 
respectively.  Head  the  columns  of  the  Returned  Sales  Journal 
likewise. 

The  Cash  Journal  may  be  constructed  of  ordinary  journal 
paper,  one  sheet  (double)  being  suflficient  for  this  exercise. 
Head  the  two  columns  on  the  left  side,  Accounts  Receivable  and 
Sundries,  respectively,  and  on  the  right  side.  Vouchers  Payable 
and  Sundries,  respectively. 

For  the  Petty  Cash  Book  rule  up  a  blank  sheet  of  paper  with 
the  columns  arranged  and  headed  as  shown  below: 


Petty  Cash  Book,  Allen  and  Goodloe 

Date 

Stationer}' 

and 
Printing 

General 
Expense 

Withdrawals 

Purchases 

Advertising 

Sundries 

Account 

Amount 

1 

„l 

Note. — The  columns  in  the  Petty  Cash  Book  must  be  such 
as  are  shown  by  experience  to  be  necessary.  Special  columns 
should  be  provided  for  the  accounts  which  receive  charges 
frequently  on  account  of  petty  cash  disbursements,  while  those 
made  infrequently  can  be  provided  for  in  the  Sundries  column. 

To  construct  the  General  Journal  use  a  sheet  of  six-column 
journal  paper,  heading  the  first  three  columns,  respectively, 
Vouchers  Payable,  Notes  Receivable,  and  Sundries,  and  the  last 
three  columns,  respectively.  Accounts  Receivable,  Notes  Payable, 


132  ACCOUNTS  IN   THEORY  AND  PRACTICE 

and  Sundries.  The  first  three  columns  are  debit  columns  and 
the  last  three  columns  are  credit  columns. 

To  construct  the  Voucher  Register  use  a  single  sheet  of  twelve- 
column  journal  paper.  Head  the  columns  as  shown  below, 
making  such  alterations  and  additions  as  may  be  necessary  to 
bring  it  into  conformity  with  the  following  outline  (page  134). 

It  is  possible,  when  the  Voucher  Register  is  properly  con- 
structed, to  make  most  charges  through  it;  consequently  the 
credit  side  of  the  Cash  Journal  is  used  exclusively  for  charging 
Vouchers  Payable  when  payment  is  made. 

In  practice  it  is  customary  to  have  vouchers  printed  in  pads. 
Upon  the  face  of  the  voucher  is  space  for  the  following  informa- 
tion: 

Name  of  concern. 

Name  of  creditor. 

Voucher  No. 

Check  No. 

Details  of  items  purchased. 

Approval  of  proper  officials. 

Receipt  of  creditor. 

• 

Upon  the  reverse  side  are  listed  the  various  accounts  to  which 
charges  may  be  made  for  items  listed  in  the  voucher,  with  money 
columns  for  the  amounts.  It  is  from  this  distribution  that 
entry  is  made  in  the  Voucher  Register. 

Numerous  variations  from  the  arrangement  suggested  above 
may  be  found.  Sometimes  voucher  and  check  are  combined 
and  called  the  "voucher  check."  This  plan  makes  certain  the 
return  of  the  voucher  properly  receipted. 

The  next  step  is  to  open  the  new  books  of  Allen  and  Goodloe 
with  an  entry  in  the  General  Journal  charging  the  assets  invested 
and  crediting  liabilities  and  the  partners'  capital  accounts. 
Enter  the  debits  in  the  Sundries  debit  column  and  the  credits 
.'n  the  Sundries  credit  column.  Check  cash  ( 1/ )  in  the  General 
Journal  and  enter  it  in  the  Cash  Journal,  writing  "Balance"  in 
the  explanation  column  and  placing  the  amount  in  the  Sundries 
column.  Post  these  to  the  General  Ledger,  opening  the  accounts 
therein  as  follows: 

Capital — A.  J.  Allen page  1,  top. 

Capital — R.  T.  Goodloe page  1,  middle. 

Buildings page  2,  top. 

Inventory page  2,  middle. 


THE  VOUCHER  REGISTER— PRACTICE  133 

Insurance  Prepaid page  3,  top. 

Furniture  and  Fixtures page  3,  middle. 

Notes  Receivable page  4,  top. 

Cash page  4,  middle. 

Salaries  Prepaid page  5,  top. 

Vouchers  Payable page  6,  top. 

Mortgage  on  Building page  6,  middle. 

Next  enter  the  individual  accounts  receivable  in  the  Accounts 
Receivable  Ledger,  two  to  a  page,  and  in  the  order  shown  in 
Schedule  1.  For  explanation  write  in  the  explanation  column 
in  the  Accounts  Receivable  Ledger  the  word  Balance.  Also 
enter  the  individual  vouchers  payable  in  the  Voucher  Register, 
numbering  them  in  the  Vo.  No.  column,  1,  2,  3,  and  so  on,  enter- 
ing the  amounts  in  the  vouchers  payable  column,  and  placing  a 
check  mark  ( K )  beside  each  amount  to  indicate  that  it  has  al- 
ready been  carried  to  the  General  Ledger  through  the  opening 
journal  entry.  Total  the  vouchers  payable  and  the  discount  on 
purchases  columns  and  under  the  totals  draw  double  lines. 
The  totals  should  be  $3295.46  and  $2L54,  respectively. 

In  practice  the  unpaid  vouchers  are  filed  in  an  Unpaid  Vouchers' 
Tickler.  When  paid  they  are  transferred  to  a  Paid  Vouchers' 
File.  Sometimes  the  practice  is  followed  of  attaching  the  re- 
turned check  to  the  paid  voucher;  sometimes  the  returned  checks 
are  filed  separately. 

Following  are  the  transactions  of  Allen  and  Goodloe  for  the 
month  of  January: 

Jan.  1.  Pay  the  Daily  News  Co.  with  check,  $10  for  current  advertising. 
Sell  on  account  to  B.  A.  Barton,  mdse.,  $15.20,  and  to  G.  J.  Winters  $61 .75. 
Pay  from  petty  cash,  $0.75  for  a  telegram  (General  Expense)  and  $1.20  for 
stationery. 

Note. — Enter  the  charge  for  advertising  in  the  Voucher 
Register,  writing  the  name  of  the  creditor — The  Daily  News  Co. 
— in  the  Customer  column,  and  then  place  the  amount  in  the 
column  headed  Advertising.  Place  "1/1"  in  the  Date  column 
under  Payment,  and  "Ck.  #1 "  in  the  How  Pd.  column.  Charge 
Vouchers  Payable  in  the  Cash  Journal,  $10.00.  Enter  the  sale 
to  B.  A.  Barton  in  the  Sales  Journal,  placing  the  amount  in  the 
Totals  column.  This  entry  differs  from  an  entry  in  the  General 
Journal  in  that  but  one  line  is  required,  thus: 
B.  A.  Barton  Extensions    Totals 

15.20 
Also  make  the  entry  for  G.  J.  Winters. 


134 


ACCOUNTS  IN   THEORY  AND  PRACTICE 


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Before  making  the  payment  from  petty  cash 
it  will  be  necessary  to  establish  a  petty  cash 
fund.  Like  other  disbursements  this  should 
be  charged  in  the  Voucher  Register.  Write 
"Cash"  in  the  explanation  column,  "13"  in 
the  Vo.  No.  column,  the  amount  (make  it  $100) 
in  the  Vouchers  Payable  column  and  also  in 
the  Sundries  amount  column,  writing  "Petty 
Cash"  in  the  column  headed  Account.  Since 
this  is  paid  at  once  by  drawing  a  check  to 
cash,  place  "1/1"  in  the  Date  column  under 
Payment  and  "Ck.  #2"  in  the  How  Pd. 
column.  In  the  Cash  Book  write  "Cash" 
in  the  explanation  column  and  carry  the 
amount  into  the  Vouchers  Payable  column. 

The  payment  from  Petty  Cash  should  next 
be  entered  in  the  Petty  Cash  Book  under 
date  of  Jan.  1,  and  extended  into  the  General 
Expense  column  ($0.75)  and  the  Stationery 
and  Printing  column  ($1.20). 

The  Petty  Cash  Book  may  be  handled  in 
different  ways.  Thus  each  payment  may  be 
entered  separately,  or  the  petty  cash  dis- 
bursements for  the  day  may  be  combined  and 
the  distribution  of  the  total  made  to  the 
proper  columns.  As  explained  in  the  pre- 
ceding chapter  its  purpose  is  to  avoid  drawing 
checks  in  payment  of  small  amounts  and  at 
the  same  time  permit  the  deposit  of  all  cash 
receipts  in  the  bank;  which  means  that  all 
disbursements  are  ultimately  represented  by 
checks. 

Jan.  2.  Pay  Johnson  &  Co.  in  full  of  account, 
$378.60,  taking  a  discount  on  that  amount  of  2%. 

This  illustrates  one  of  the  several  compli- 
cations likely  to  arise  in  connection  with  the 
use  of  the  Voucher  Register.  If  it  is  known 
at ^  the  time  of  opening  the  new  books  that 
the  discounts  will  be  all  taken,  then  the 
voucher    should    be   made   out  for  the  net 


THE  VOUCHER  REGISTER— PRACTICE  135 

amount  and  the  discount  shown  in  the  discount  on  purchases 
column.  If,  for  purposes  of  illustration,  we  assume  that  this 
was  not  known,  it  now  becomes  necessary  to  adjust  the  credit  to 
vouchers  payable,  which  was  placed  at  $378.60.  This  adjust- 
ment may  be  made  in  different  ways.  One  way  is  to  provide  a 
Discount  on  Purchases  column  in  the  Cash  Journal  and  when 
making  the  disbursement  charge  vouchers  payable  for  the  full 
amount  and  enter  the  discount  in  the  Discount  on  Purchases 
column.  This  is  the  best  method  except  when  there  is  certainty 
of  making  all  discounts,  in  which  case  the  voucher  should  be 
made  out  for  the  net  amount  and  the  discount  entered  in  the 
Discount  on  Purchases  column  in  the  Voucher  Register.  Follow 
this  plan,  as  all  discounts  will  be  taken.  Make  entry  in  the 
Cash  Journal  entering  the  net  amount  in  the  Vouchers  Payable 
column  and  writing  the  name  of  the  payee  in  the  explanation 
column. 

Jan.  3.  Sell  on  account  to  O.  D.  Dunn,  $120.15,  and  to  L.  O.  Donovan, 
$62.30.  G.  J.  Winters  pays  account  in  full.  Petty  cash  payments  for 
General  Expense,  $8.40. 

Jan.  4.  Pay  Atkins  and  Jones  in  full  of  account,  taking  the  discount  of 
1%. 

Jan.  6.  Pay  the  Wholesale  Grocery  Co.  in  full  of  account,  taking  the 
discount  of  2%. 

Note. — In  both  cases  charge  Vouchers  Payable  for  the  net 
amount  in  the  Cash  Journal. 

Jan.  7.  Cash  sales  for  week,  $920.16.  Receive  invoice  from  the  Whole- 
sale Grocery  Co.  for  mdse.,  $147.30,  2%  10  days,  net  30  days.  Petty  cash 
disbursements:  purchases,  $11.40;  advertising,  $8.30;  general  expense, 
$5.12.  Sell  on  account  to  J.  M.  Ogden,  $19.00;  to  K.  W.  Brown,  $50.00; 
to  A.  A.  Alden,  $10.40.  The  Wildwood  Club  and  A.  A.  Alden  pay  in  full 
to  date.     Enter  cash  sales  in  the  Sundries  column  in  the  Cash  Journal. 

Note. — Since  it  is  the  policy  of  the  firm  to  take  all  cash 
discounts,  enter  the  purchase  from  the  Wholesale  Grocery  Co. 
in  the  Vouchers  Payable  column  in  the  Voucher  Register  for 
net,  the  discount  in  the  Discount  on  Purchases  column,  and  the 
total  in  the  Purchases  column.  In  practice,  the  voucher  would 
now  be  placed  in  the  Vouchers  Payable  Tickler  for  the  discount 
day. 

Jan.  8.  Receive  invoice  from  Allen  and  Allen  for  show  case,  $50.00  net, 
and  mdse.,  $100,  terms  2/10,  net  30. 


136  ACCOUNTS  IN   THEORY  AND  PRACTICE 

Note. — Enter  this  in  the  Voucher  Register,  $148  in  the 
Vouchers  Payable  column,  $2.00  in  the  Discount  on  Purchases 
column,  $100  in  the  Purchases  column  and  $50.,  under  Sundries, 
writing  *'Fur.  &  Fixt."  in  the  Account  column  and  the  amount 
in  the  Amount  column.  Had  it  been  desirable  to  pay  this  item 
in  parts  on  different  days  separate  vouchers  should  have  been 
made  out. 

Jan.  9.  Pay  Burton  and  Fitch  voucher  payable  no.  1  for  $21.3.00;  also 
Clyde  Manufacturing  Co.  voucher  payable  no.  2,  $275.40.  Petty  cash 
payments:  purchases,  $11.40;  general  expense,  $6.37. 

Jan.  13.  Receive  invoice  from  Gordon  &  Smith,  mdse.,  $110.00,  net 
15  days.     Pay  Gordon  &  Smith  voucher  payable  no.  11,  $225.00. 

Jan  14.  Receive  invoice  from  J.  Loomis,  for  furniture  for  store,  $75.00, 
net  15  days.  Sell  on  account  to  R.  R.  Rutherford,  mdse.,  $15.00.  Pay  help 
for  two  weeks,  $350.00.  Enter  voucher  for  petty  cash  payments  made  and 
draw  check  to  replenish  the  fund.     Cash  sales  for  week,  $872.41, 

Note. — The  voucher  is  made  out  for  the  full  amount  of  tl.o 
wages  and  entered  in  the  Voucher  Register.  Write  "Cash  for 
wages"  in  the  explanation  column.  Next  make  entry  in  the 
Cash  Journal  for  check  drawn  for  that  amount.  From  this 
cash  fund  the  individual  wage  earners  are  paid. 

In  entering  the  voucher  for  petty  cash  in  the  Voucher  Register, 
write,  "Cash  for  petty  cash,  2  wks."  in  the  explanation  column 
and  distribute  the  amount  properly  in  the  distribution  columns. 
These  are  first  determined  by  totaling  the  distribution  columns 
of  the  Petty  Cash  Book  and  ruling  it  up  to  indicate  that  a  voucher 
is  being  drawn  to  reimburse  the  petty  cash  fund.  When  the 
check  is  cashed  and  the  amount  turned  into  petty  cash  the  fund 
again  stands  at  $100. 

Jan.  15.  Mr.  Allen  withdraws  $5.00  from  petty  cash  for  personal  use. 
Sell  mdse.  on  account  to  N.  N.  Smith,  $38.20. 

Jan.  16.  Pay  Wholesale  Grocery  Co.  voucher  no.  14  of  Jan.  7,  $147.30, 
less  discount.  Petty  cash  disbursements :  general  expense,  $14.60;  purchases 
$18.92. 

Jan.  17.     Pay  Allen  and  Allen  voucher  no.  15,  of  Jan.  8,  $148.00. 

Jan.  18.  R.  R.  Rutherford  returns  goods,  receiving  credit,  $10.20; 
A.  K.  Cornwall  pays  account  in  full,  $813.50. 

Note. — Enter  the  returned  sales  transaction  in  the  Returned 
Sales  Journal,  writing  A.  K.  Cornwall  in  the  explanation  column 
and  placing  the  amount  in  the  Totals  column.  Post  to  the  credit 
of  Cornwall's  account  in  the  Accounts  Receivable  Ledger. 


THE  VOUCHER  REGISTER— PRACTICE  137 

Jan.  20.  Petty  cash  payments:  R.  T.  Goodloe,  withdrawals,  $11.00; 
purchases,  $8.40;  general  expense,  $5.10.  Pay  L.  O.  March  voucher  pay- 
able no.  5,  $23.00;  also  S.  Tompkms  &  Son,  voucher  payable  no.  9,  $140.00. 

Jan.  21,  Cash  sales  for  week,  $1315.42.  Pay  Gordon  &  Smith  voucher 
payable  no.  16,  $110.00. 

Jan.  22.     B.  A.  Barton  returns  goods,  $5.00. 

Jan.  23.  Receive  invoice  of  mdse.  from  Wholesale  Grocery  Co.,  2/10, 
net  30,  $127.00. 

Jan.  24.  Return  mdse,  purchased  to  Wholesale  Grocery  Co.  $55.00,  and 
to  S.  Sisson  &  Sons,  $25.50.  Petty  cash  payments:  general  expense,  $2.13; 
purchases,  $18.00. 

Note. — The  returns  of  merchandise  to  the  Wholesale  Gro- 
cery Co.  and  to  S.  Sisson  &  Sons  illustrate  some  of  the  possible 
complications  that  arise  when  the  voucher  register  is  used.  If 
the  vouchers  have  not  been  paid  the  best  procedure  is  to  cancel 
the  original  vouchers  and  make  out  new  ones  for  the  amount 
less  returns.  In  the  case  of  S.  Sisson  &  Sons,  it  will  necessitate 
changing  the  total  of  unpaid  vouchers.  Make  an  entry  in  the 
General  Journal  charging  Vouchers  Payable  and  crediting  In- 
ventory for  $25.50.  Charge  Vouchers  Payable  in  the  debit 
Sundries  column  and  credit  Inventory  in  the  credit  Sundries 
column.  Make  proper  changes  in  amounts  in  the  voucher 
Register.  In  the  case  of  the  Wholesale  Grocery  Co.  the  entry 
in  the  Voucher  Register  should  be  canceled  by  drawing  a  line 
through  it  and  a  new  voucher  (No.  21)  made  out.  The  discount 
is  of  course  reduced  from  $2.54  to  $1.44,  and  the  amount  charged 
in  the  Purchases  column  is  reduced  fom  $127.00  to  $72.00.  An 
alternative  method  is  to  leave  the  original  figures  uncanceled, 
entering  the  reductions  in  amounts  in  red  ink  just  above  the 
original  amounts.  These  must  then  be  deducted  when  the 
columns  are  added.  When  this  method  is  followed  the  original 
voucher  may  be  canceled  and  a  new  one  made  out  (in  which  case 
the  number  of  the  vouchers  in  the  Vouchers  No.  column  must  be 
changed),  or  a  "charge  voucher,"  usually  of  different  colored 
paper,  may  be  attached  to  the  original  voucher,  indicating  the 
changes  to  be  made  in  the  Voucher  Register. 

Jan.  25.     Sell  on  account  to  the  Wildwood  Club,  $40.00. 

Jan.  27.     Pay  J.  Loomis,  voucher  payable  no.  17,  $75.00  net. 

Jan.  28.     R.  R.  Rutherford  pays  account  in  full,  $115.20. 

Jan.  31.  O.  D.  Dunn  gives  note  due  in  2  mo.  interest  at  6%  in  payment 
in  full  of  his  account.  Pay  help  $378.00.  Cash  sales  since  Jan.  21,  $1140.- 
00.     Draw  check  to  replenish  petty  cash,  making  proper  entry.      Purchase 


138  ACCOUNTS  IN  THEORY  AND  PRACTICE 

adjoining  building  from  A.  A.  Smith  for  $4000.00,  paying  $1000.00  cash  and 
giving  note  due  in  6  mo.  for  balance. 

Note. — The  entry  for  the  purchase  of  the  building  will  be 
entered  in  the  Voucher  Register  as  voucher  no.  23.  Write 
"Cash  and  Note"  in  the  Terms  column,  $4,000  in  the  Vouchers 
Payable  column  and  extend  it  into  the  Amount  column  under 
Sundries,  writing  "Buildings  and  Land"  in  the  Account  column. 
In  the  Payment  columns,  write  "1/31 "  under  Date  and  "Ck  #18 
&  Note"  under  How  Pd. 

All  entries  being  made,  draw  a  line  under  the  various  amount 
columns  in  the  Voucher  Register  and  bring  the  totals  of  all 
columns  below  it.  The  totals  of  the  credit  columns,  Vouchers 
Payable,  and  Discount  on  Purchases,  when  added  together 
($5,483.39)  should  equal  the  totals  of  the  distribution  columns. 

Next  post  the  total  of  the  Vouchers  Payable  column  to  the 
credit  side  of  the  Vouchers  Payable  Account  in  the  General 
Ledger,  the  total  of  the  Discount  on  Purchases  column  to  the 
credit  of  the  Discount  on  Purchases  account  in  the  General 
Ledger,  and  the  totals  of  the  distribution  columns  to  the  debit 
of  the  proper  accounts  in  the  General  Ledger,  excepting  the  Sun- 
dries column  from  which  the  items  must  be  posted  separately 
to  Furniture  and  Fixtures,  $50.00  and  $75.00,  A.  J.  Allen, 
withdrawals,  $5.00,  R.  T.  Goodloe,  withdrawals,  $11.00,  and 
Buildings  and  Land,  $4,000.00.  Check  ( 1/ )  each  item  a<^  it  is 
posted  to  avoid  posting  it  twice.  Use  the  abbreviation  "V.R.I." 
in  the  General  Ledger  folio  column.  Post  all  other  books. 
Interest  on  the  mortgage  on  Buildings  is  at  6%,  payable  semi- 
annually June  30  and  Dec.  31.  Make  entry  for  interest  accrued 
on  the  mortgage  in  the  General  Journal.  Take  a  trial  balance 
of  the  General  Ledger.  Submit  a  Profit  and  Loss  Account  and 
a  Balance  Sheet.     The  inventory  as  at  Jan.  31  is  $8,000. 


CHAPTER  XXI 

THE  PRIVATE  LEDGER 

Use  of  the  Private  Ledger. — Sometimes  it  is  desirable  to 
keep  certain  ledger  accounts,  particularly  those  relating  to 
proprietorship,  in  a  Private  Ledger,  where  they  are  subject  to 
inspection  by  none  except  the  manager  or  a  trusted  employee. 
The  accounts  thus  protected  from  the  common  observation 
may  be  few  or  many,  as  required.  Generally  they  are  few  in 
number  and  of  a  character  requiring  only  infrequent  changes 
through  postings.  Corresponding  to  the  Private  Ledger  there 
should  be  kept  a  Private  Journal  in  which  all  entries  affecting 
Private  Ledger  accounts  are  kept.  To  illustrate  the  method 
of  setting  up  a  Private  Ledger,  assume  that  the  following  is  the 
final  trial  balance  of  the  General  Ledger  of  Allen  Graham,  as 
at  December  31,  1916: 

Balance  Sheet  Allen  Graham,  as  at  Dec.  31, 1916 : 

Allen  Graham^Capital $10,000 

Real  Estate $  8,000 

Inventory.  Dec.  31,  1916 5,000 

Cash 800 

Accounts  Receivable 3,000 

Accounts  Payable 2,000 

Mortgage 4,800 


t  $16,800  $16,800 


If>  now,  Graham  desires  to  transfer  his  capital  account  and 
the  accoilnts  for  Mortgage  and  Real  Estate  to  a  Private  Ledger, 
it  is  necessary  to  close  these  accounts  in  the  General  Ledger  by 
the  following  entry  in  the  General  Journal : 

Allen  Graham— Capital $10,000 

Mortgage 4,800 

To  Real  Estate $8,000 

Private  Ledger 6,800 

139 


140  ACCOUNTS  IN   THEORY  AND  PRACTICE 

After  this  entry  is  posted  a  trial  balance  of  the  General  Ledger 
appears: 

Inventory,  Dec.  31,  1916 $5,000 

Private  Ledger $6,800 

Cash 800 

Cash 800 

Accounts  Receivable 3,000 

Accounts  Payable 2,000 

$8,800     $8^800 


In  the  Private  Journal  the  following  entry  is  made: 

General  Ledger $6,800 

Real  Estate 8,000 

To  Allen  Graham— Capital $10,000 

Mortgage    4,800 

After  this  entry  is  posted  to  the  Private  Ledger  a  trial  balance 
taken  from  that  ledger  appears  thus: 

General  Ledger $  6,800 

Real  Estate 8,000 

Allen  Graham— Capital $10,000 

Mortgage 4,800 

$14,800     $14,800 


It  is  only  when  a  transaction  occurs  which  affects  accounts 
in  both  the  Private  and  General  Ledgers  that  the  balancing 
accounts,  Private  Ledger  and  General  Ledger,  are  affected. 
To  illustrate,  if  cash  is  received  in  payment  of  an  account  re- 
ceivable the  entry  is  made  in  the  Cash  Journal  and  posted  to  the 
debit  of  cash  and  to  the  credit  of  accounts  receivable,  both  of 
which  accoi/nts  are  in  the  General  Ledger,  if,  on  the  other  hand 
a  parcel  of  real  estate  is  sold  for  $2,000,  one  account  in  the 
Private  Ledger  and  one  account  in  the  General  Ledger  will  be 
affected,  namely,  Real  Estate  and  Cash.  Therefore  instead 
of  crediting  Real  Estate  in  the  Cash  Journal,  Private  Ledger  is 
credited,  thus: 

Cash $2,000.00 

To  Private  Ledger $2,000.00 

and  in  the  Private  Journal  the  following  entry  is  required: 

General  Ledger. . . ". 2000.00 

To  Real  Estate 2000. 00 


THE  PRIVATE  LEDGER  141 

In  this  way  any  accounts,  real  or  nominal,  may  be  kept  in  the 
Private  Ledger.  It  is  entirely  feasible  to  set  up  the  Profit  and 
Loss  account  in  the  Private  Ledger  by  closing  out  the  debit  and 
credit  nominal  accounts  into  the  Private  Ledger  account  in  the 
General  Ledger,  and  then  in  the  Private  Journal,  charging  the 
debit  nominal  balances  to  profit  and  loss  and  crediting  General 
Ledger  account,  and  crediting  the  credit  nominal  items  to  profit 
and  loss,  at  the  same  time  charging  General  Ledger  account. 


CHAPTER  XXII 

THE  PRIVATE  LEDGER— PRACTICE 

Problem  1. — Following  is  the  balance  sheet  of  Amos  Chandler, 
as  at  Dec.  31,  1919: 

Amos  Chandler,  Capital $18,500 

Buildings  and  Real  Estate $  8,400 

Cash 900 

Accounts  Receivable 2,700 

Notes  Receivable 400 

Inventory,  1/1,  '19 6,000 

Mortgage  on  Buildings 2,000 

Supplies 200 

Furniture  and  Fixture 400 

Accounts  Payable 100 

Investments 2,500 

$21,500    $21,500 

Chandler  desires  to  set  up  a  Private  Ledger  to  contain  accounts 
for  capital,  investments,  and  mortgage  on  buildings.  Show 
entries  necessary  in  the  General  and  Private  Journals  and  submit 
trial  balances  for  the  General  and  Private  Ledgers  after  these 
entries  have  been  posted. 

Solution,  Problem  1. — The  entry  in  the  General  Journal  is  as 
follows: 

Amos  Chandler,  Capital $18,500 

Mortgage  on  Buildings 2,000 

To  Investments $2,500 

Private  Ledger 18,000 

To   transfer  accounts   to    Private   Ledger   of    Amos 
Chandler. 

The  entry  in  the  Private  Journal  is  as  follows : 

General  Ledger $18,000 

Investments 2,500 

To  Amos  Chandler,  Capital 18,500 

Mortgage  on  Buildings 2,000 

To  bring  accounts  into  the  Private  Ledger  of  Amos 
Chandler. 

142 


THE  PRIVATE  LEDGER— PRACTICE  143 

Trial  Balance,  General  Ledger: 

Buildings  and  Real  Estate $8,400 

Cash 900 

Accounts  Receivable 2,700 

Notes  Receivable 400 

Inventory,  1/1,  '19 6,000 

Supplies 200 

Furniture  and  Fixtures 400 

Accounts  Payable $  1,000 

Private  Ledger 18,000 

$19,000  $19,000 

Trial  Balance,  Private  Ledger : 

General  Ledger $18,000 

Investments 2,500 

Amos  Chandler,  Capital $18,500 

Mortgage  on  Buildings 2,000 

$20,500  $20,500 


Problem  2.— Amos  Chandler,  on  Jan.  15,  1920,  sells  $2,000  of 
his  investments  at  cost  ($2,000).     Make  proper  entries. 

On  Jan.  31,  he  pays  $1,000  cash  on  the  mortgage  on  buildings. 
Make  proper  entries. 

Problem  3. — The  trial  balance  of  the  General  Ledger  of  Amos 
Chandler  as  at  Dec.  31,  1920,  is  as  follows: 

Buildings  and  Real  Estate $8,400 

Cash , 3,000 

Accounts  Receivable 2,800 

Notes  Receivable 400 

Inventory,  1/1,  1920 6,000 

General  Expense 700 

Purchases 13,700 

Sales $15,000 

Supplies  (consumed) 300 

Furniture  and  Fixtures 400 

Accounts  Payable 1,200 

Private  Ledger 19,500 

$35,700  $35,700 


The  inventory  as  of  Dec.  31,  1920,  is  $7,000.  Interest  has 
accrued  from  July  1,  1920,  on  the  mortgage  which  stands  at 
$1,000  and  bears  interest  at  6%.  This  interest  accrued  has 
not  been  brought  into  the  accounts.  Close  the  books,  setting  up 
the  Profit  and  Loss  Account  in  the  Private  Ledger.  Submit 
balance  sheet  as  at  Dec.  31,  1920. 


144  ACCOUNTS  IN   THEORY  AND  PRACTICE 

BIBLIOGRAPHY 
Part  III.     Expansion  of  Accounting  Records 

Dickinson,  A.  L.  Accounting  Practice  and  Procedure.  New  York, 
1913.     Chapter  I. 

EsQUERR^,  P.  J.  Applied  Theory  of  Accounts.  New  York,  1914.  Chap- 
ters VIII-XVI. 

Oilman,  S.     Principles  of  Accounting.     Chicago,  1916.     Chapter  III. 

Hatfield,  H.  R.  Modern  Accounting.     New  York,  1909.    Chapter  XIX. 

Kester,  R.  B.  Accounting  Theory  and  Practice.  New  York,  1917. 
Vol.  I. 

Klein,  J.  J.     Elements  of  Accounting.     New  York,  1913.     Chapter  III. 

Paton,  W.  a.  and  Stevenson,  R.  A.  Principles  of  Accounting.  New 
York,  1918.     Chapter  V. 

Sprague,  C.  E.  The  Philosophy  of  Accounts.  New  York,  1908.  pp. 
82-129. 


PART  IV 
CORPORATION  ACCOUNTING 

CHAPTER  XXIII 
THE  CORPORATION— SPECIAL  CONSIDERATIONS 

Corporation  Defined. — The  corporation  is  a  form  of  organiza- 
tion possessing  certain  features  which  commend  it  to  most  enter- 
prises carried  out  on  a  fairly  large  scale.  It  affords  certain 
advantages  which  neither  the  sole  proprietorship  nor  the  partner- 
ship enjoys.  On  the  other  hand  certain  requirements  are  imposed 
upon  the  corporation  from  which  the  other  two  forms  of  organiza- 
tion are  free.  A  corporation,  according  to  the  definition  given 
by  Chief  Justice  John  Marshall,  in  the  Dartmouth  College  Case, 
is  "an  artificial  being,  invisible,  intangible  and  existing  only 
in  contemplation  of  law."  Consequently  the  corporation  is  an 
offspring  of  the  law,  exists  only  by  consent  of  the  law,  and  may  be 
dissolved  by  the  law. 

Limitations  of  the  Partnership. — With  the  growth  of  their 
capital  and  the  extension  of  their  markets,  in  brief,  with  the 
development  of  their  interests  generally,  the  limitations  of  the 
primitive  forms  of  organization  become  apparent.  The  sole 
proprietor  frequently  lacks  ability  or  capital,  or  both,  to  enlarge 
his  plant  to  meet  growing  needs.  He  may  supply  the  defect 
by  accepting  one  or  more  partners,  but  the  growth  of  partnerships 
is  quite  restricted  beyond  a  certain  point.  When  there  are  only 
a  few  partners  the  usual  operations  of  the  organization  will 
ordinarily  proceed  without  friction.  When,  however,  to  obtain 
an  increase  of  capital,  or  for  other  reason,  the  number  of  partners 
is  increased,  the  point  is  soon  reached  when  the  number  of  the 
partners  is  an  impediment.  Recalling  the  causes  of  partnership 
dissolution  will  indicate  this. 

Advantages  of  Incorporation. — Perhaps  the  two  most  impor- 
tant considerations  that  lead  to  incorporation  are  (a)  the  need 
for  limited  liability,  and  (6)  unlimited  possibilities  of  growth  of 
the  corporation. 

10  145 


146  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Limited  Liability. — A  partner's  liability  for  the  debts  of  his 
partnership  are  not  limited  to  his  investment  therein,  but  his 
private  fortune  as  well  may  be  confiscated  for  their  payment,  if 
necessary.  Naturally,  this  fact  serves  as  a  deterrent  to  those 
who  are  considering  the  advisability  of  becoming  partners  in  any 
enterprise.  The  corporate  form  of  organization  obviates  this 
difficulty  by  placing  a  specific  limitation  to  the  capitalist's 
liabihty.  What  this  limitation  is  is  determined  by  the  statutes 
of  the  state  in  which  the  corporation  is  chartered.  Usually 
one's  liabihty  is  limited  to  his  actual  investment  in  a  corporation, 
but  to  this  rule  there  are  some  exceptions,  notably  in  case  of 
national  banks  where  one  is  liable  for  twice  the  amount  of  his 
investment.  In  two  states,  moreover,  the  statutes  make  ex- 
ceptional provisions.  In  Minnesota  a  stockholder's  liability  is 
but  partly  limited,  while  in  California  a  stockholder's  liability 
is  unlimited,  except  that  it  must  be  prorated  on  the  basis  of 
holdings. 

Possibilities  of  Growth. — Provision  for  future  expansion  is  an 
important  consideration.  Sometimes  this  growth  is  more,  some- 
times less  rapid,  than  anticipated.  It  is  not  always  possible, 
therefore,  and  rarely  desirable,  to  provide  capital  at  organization 
time  for  distant  future  development.  But  there  should  remain 
avenues  through  which  such  capital  can  be  secured  without 
great  difficulty  when  it  is  needed.  The  corporation  is  well 
adapted  to  meet  this  requirement.  The  readiness  with  which  it 
permits  the  expansion  of  its  capital,  and  the  manner  in  which  the 
ownership  of  that  capital  may  be  transferred  from  party  to  party 
are  two  corporate  essentials. 

The  units  into  which  the  capital  of  a  corporation  may  be 
divided  are  called  stocks.  When  there  exists  a  sum  total  of 
capital  which  exceeds  the  par  value  of  the  stocks  it  is  called 
surplus.  The  amount  of  the  stock  which  a  corporation  is  author- 
ized to  issue  is  specifically  stated  in  the  charter.  The  amount 
of  the  stock  which,  at  any  time  after  incorporation,  is  outstand- 
ing, that  is,  which  has  been  sold  to  secure  capital,  is  the  issued 
stock.  Usually  the  amount  of  the  authorized  stock  is  placed  at 
a  considerably  higher  figure  than  the  amount  which  the  corpora- 
tion will  care  to  issue  for  a  considerable  time;  thus  a  portion  of 
the  authorized  stock  is  held  in  reserve  to  be  issued  when,  in 
future,  more  capital  is  required.  Moreover,  the  number  of 
shares  of  stock  is  usually  so  large  that  the  worth  of  a  single  share 


THE  CORPORATION— SPECIAL  CONSIDERATION        147 

is  not  usually  very  much.  Each  share  is  generally  given  an 
arbitrary  or  par  value,  usually  $100,  but  sometimes  much  less, 
possibly  $5  or  $10.  This  par  value,  or  face  value,  must  not  be 
confused  with  the  market  price  of  a  share  of  stock,  for  the  par 
value  is  wholly  arbitrary  while  the  selling  price  is  determined  by 
the  equity,  that  is  the  actual  value,  which  underlies  the  share. 
The  selling  price  may  be  either  below  or  above  par. 

Status  of  Stockholder. — The  relatively  small  value  of  a  share 
of  stock  makes  it  possible  for  the  corporation  to  appeal  to  a  very 
wide  range  of  people  who  have  money  to  invest.  Moreover, 
the  ownership  of  any  number  of  shares  is  readily  transferable 
from  party  to  party  without  in  any  way  influencing  the  routine 
activities  of  the  corporation.  Although  the  control  of  the  cor- 
poration rests  ultimately  in  the  stockholders,  their  influence 
makes  itself  felt  indirectly  through  the  board  of  directors,  which 
is  elected  by  the  stockholders,  and  to  which  the  stockholders 
delegate  nearly  all,  if  not  all,  of  the  actual  work  of  management 
and  supervision.  Where  the  burden  is  thus  placed  upon  the 
shoulders  of  a  few — for  the  board  of  directors  rarely  consists  of 
more  than  twenty  men — the  interest  of  the  stockholder  in  the 
current  affairs  of  the  company  is  often  slight,  frequently  too 
slight  for  his  own  good.  However  that  may  be,  the  relationship 
existing  between  stockholders  is  not  personal  in  the  sense  that 
partners  are  related  to  one  another.  Hence  there  is  no  need  of 
terminating  the  company's  existence  when  a  stockholder  dies,  or 
is  mentally  incapacitated,  or  does  any  of  the  things  which  cause 
the  dissolution  of  partnerships. 

When  a  partner  dies,  unless  some  agreement  has  been  previ- 
ously made,  modifying  the  common  law,  the  partnership  must 
be  dissolved  and  its  assets  sold  to  satisfy  creditors,  any  balance 
remaining  being  distributed  among  the  living  partners  and  the 
estate  of  the  deceased  partner.  When  a  stockholder  dies  the 
corporation  is  usually  not  affected  in  any  way,  except  perhaps 
through  its  loss  of  his  services,  if  he  happens  to  have  been  an 
official  or  director.  His  stock  will  pass  to  his  heirs  according  to 
the  laws  of  personal  property.  The  recipients  of  it  will  continue 
to  hold  it  and  exercise  any  rights  and  privileges  which  were 
accorded  to  the  original  holder. 

Close  and  Open  Corporations. — A  corporation  may  be  close 
or  open.  In  case  of  a  close  corporation  the  stock  is  usually  held 
by  a  comparatively  few  persons,  sometimes  practically  all  by 


148  ACCOUNTS  IN   THEORY  AND  PRACTICE 

one  person,  and  consequently  transfers  of  its  stock  take  place 
but  infrequently.  In  case  of  an  open  corporation  there  are 
usually  a  considerable  number  of  stockholders  and  many  trans- 
fers of  stock  are  made  from  sellers  to  purchasers.  The  number 
of  stockholders  oftentimes  runs  into  the  thousands.  There  are 
114,779  stockholders  in  the  Pennsylvania  Railroad  Company' 
and  152,228  in  the  United  States  Steel  Corporation.^  When 
such  is  the  case  special  machinery  must  be  provided  to  facilitate 
the  transfers  of  stock.  For  this  purpose  one  or  more  stock  books 
or  ledgers  are  kept.  In  the  stock  ledger  space  is  provided  for  the 
name  of  each  stockholder,  the  number  of  shares  of  stock  pur- 
chased by  him,  the  date  of  the  transfer,  the  number  of  the  stock 
certificate  issued  to  him,  and  such  other  data  as  may  be  desired. 
In  some  states,  as  New  York,  the  form  of  the  stock  ledger  is 
prescribed  by  law. 

The  Stock  Certificate. — The  stock  certificate  is  a  document 
which  affords  visible  evidence  of  the  ownership  of  stock.  Some- 
times, when  the  work  of  engraving  these  certificates  is  not  com- 
pleted, receipts  are  issued  to  the  original  purchasers  of  stock,  and 
these  are  later  exchanged  for  the  engraved  certificates.  Simi- 
larly, when,  as  often  occurs,  the  subscribers  to  the  stock  of  a 
company  pay  for  it  in  instalments,  that  is,  so  much  down,  and 
the  balance  in  specified  sums  on  stated  succeeding  dates,  receipts 
are  issued  for  the  various  instalments,  the  formal  stock  certificates 
being  issued  only  when  the  last  instalment  has  been  paid.  The 
essential  features  of  a  certificate  of  stock  are,  the  name  of  the 
owner,  the  number  and  par  value  of  his  shares,  the  number  of 
the  certificate,  the  privileges  that  attach  to  the  stock,  and  the 
validating  signatures  of  the  proper  corporation  officials.  On  the 
back  of  the  certificate  is  provided  a  form  for  transfer  of  ownership 
to  be  filled  in  by  the  owner  of  the  stock  upon  sale  of  a  part  or 
whole  of  his  interest.  Note  that  any  number  of  shares  of  stock 
may  be  represented  by  one  certificate.  Accordingly  if  one  man 
purchases  all  the  holdings  of  three  other  men,  of  any  particular 
stock,  their  three  certificates  are  canceled  and,  providing  the 
transfers  are  made  simultaneously,  one  single  certificate  is  issued 
in  their  place. 

Transfer  of  Ownership. — Upon  the  stock  market,  shares  of 
stock  are  bought  and  sold  sometimes  many  times  over  in  one 

1  As  of  Noy.  30,  1919. 

*  As  of  date  books  were  last  closed  in  1919  for  dividend  purposes. 


THE  CORPORATION— SPECIAL  CONSIDERATION        149 

day,  for  speculative  purposes.  When  this  is  done  stock  cer- 
tificates may  be  assigned  in  blank,  i.e.,  the  seller  may  sign  away 
his  interest  in  his  shares  by  merely  placing  his  signature  in  the 
proper  place  on  the  form  on  the  back  of  the  certificate  without 
designating  any  transferee.  When  this  is  done  the  certificate 
becomes  transferable  by  delivery,  and  may  be  passed  from 
hand  to  hand  without  further  formality.  When  it  finally  comes 
into  the  hands  of  an  investor  or  speculator  who  intends  to  hold 
it  for  a  time,  it  is  necessary,  for  reasons  to  be  explained,  that  he 
have  a  new  certificate  issued  in  his  own  name. 

Dividends. — Money  paid  for  the  stock  of  a  corporation  is  said 
to  be  invested.  These  who  invest  money  in  stock  expect  to 
secure  a  reasonable  income  thereon.  Income  on  stocks  is  called 
dividends.  Dividends  are  figured  as  a  percentage  of  the  par 
value  of  the  stock.  Thus  if  the  par  value  of  a  share  is  $100,  and 
the  corporation  issuing  this  stock  pays  a  dividend  of  6%  per 
annum,  payable  quarterly,  then  for  every  share  of  such  stock 
that  one  owns  he  will  receive  each  quarter  year  a  dividend  of 
$1.50.  The  advisability  of  paying  dividends  or  of  discontinuing 
their  payment  rests  with  the  board  of  directors.  They  do  not 
possess  complete  freedom  in  this  matter,  however,  for  there  are 
certain  legal  and  accounting  principles  which  they  cannot  neglect 
without  running  the  risk  of  incurring  personal  liability.  Unless 
there  are  profits,  either  current,  or  accumulated  from  previous 
years,  a  dividend  cannot  be  paid  lawfully;  for  to  do  so  would 
diminish  the  capital  invested  and  to  that  extent  lessen  the  re- 
sources to  which  creditors  might  look  for  the  satisfaction  of  their 
debts  in  case  of  insolvency.  To  the  above  rule  there  are  certain 
exceptions,  notably  in  case  of  those  companies  organized  to 
exploit  wasting  assets,  such  as  mineral  deposits,  forest  tracts, 
and  so  on.  The  time  during  which  such  a  company  can  continue 
its  operations  is  necessarily  limited  by  the  extent  of  the  resources 
which  it  exploits.  To  require  such  a  company  to  keep  its  original 
capital  intact  and  undiminished  until  the  last  bit  of  mineral  has 
been  smelted  or  the  last  tree  hewn  down  would  not  be  good  policy. 
Consequently  such  companies  may  legimately  return  something 
in  addition  to  profits  in  paying  their  dividends.  This  partly 
accounts  for  the  surprisingly  large  dividends  sometimes  paid. 
One  who  invests  money  in  such  enterprises  should  not  mistake 
his  dividends  as  pure  profits,  lest  he  find  later  on  that  in  spending 
them  he  has  spent  both  his  profits  and  his  capital. 


150  ACCOUNTS  IN   THEORY  AND  PRACTICE 

Common  and  Preferred  Stocks. — Sometimes  a  corporation 
finds  it  advisable  to  issue  stocks  with  varying  qualities  and  privi- 
leges. When  only  one  kind  of  stock  is  issued  it  is  all  common,  but 
when  two  kinds  are  issued  it  is  customary  to  classify  them  as 
preferred  and  common.  In  this  case  the  preferred  stock  posses- 
ses some  advantage  not  possessed  by  the  common  stock.  This 
advantage  may  be  in  the  form  of  a  preference  as  to  profits,  or  as 
to  assets,  or  both.  By  a  preference  as  to  profits  is  meant  that 
some  specified  dividend  must  be  paid  on  the  preferred  stock 
before  any  can  be  paid  on  the  common  stock.  When  we  speak 
of  a  six  per  cent  preferred  stock  we  mean  that  the  preferred 
stockholders  will  receive  this  dividend  in  full  out  of  profits  before 
-  the  common  stock  will  receive  any  consideration.  Just  what 
method  will  be  pursued  with  the  common  stock  after  such  pre- 
ferred stock  dividend  has  been  paid  will  be  determined  by  the 
conditions  under  which  the  two  classes  of  stock  are  issued. 
Sometimes  the  common  stock  will  receive  a  dividend  equal  to 
that  paid  the  preferred;  sometimes  it  receives  less,  sometimes 
more.  Profits  remaining  for  distribution  after  the  initial  re- 
quirements of  both  classes  of  stock  have  been  met  may  be  divided 
between  the  two  classes  of  stock  on  some  pre-arranged  basis,  or 
possibly  they  may  be  retained  as  an  addition  to  working  capital 
or  be  invested  in  extensions  and  improvements. 

Cumulative  Preferred  Stock. — If  the  preferred  stock  is  cumu- 
lative, then  in  case  there  are  not  sufficient  profits  in  any  one 
year  to  satisfy  its  dividend  requirements,  whatever  remains 
unpaid  becomes  a  lien  on  the  profits  of  succeeding  years.  Some- 
times the  unpaid  dividends  on  the  preferred  stock  accumulate 
to  a  very  large  amount,  thus  placing  the  common  stockholders 
in  a  position  where  little  hope  exists  of  receiving  any  divi- 
dend for  a  very  long  time  to  come.  For  a  long  time  preceding 
the  outbreak  of  the  European  War  in  1914,  the  International 
Mercantile  Marine  Company  did  not  pay  dividends  on  its 
cumulative  preferred  stock  with  the  result  that  these  accumu- 
lated and  unpaid  dividends  have  since  amounted  to  a  sum 
almost  equal  to  the  par  of  the  stock  itself. 

Factors  Determining  Market  Values. — When  both  preferred 
and  common  stock  are  outstanding  the  two  kinds  of  stock  will 
sell  at  prices  which  are  determined  by  a  number  of  factors,  such 
as  the  value  of  the  assets,  the  general  prosperity  of  the  company, 
the  respective  amounts  of  the  stocks  outstanding,  the  provisions 


THE  CORPORATION— SPECIAL  CONSIDERATION        151 

regarding  the  dividends  and  any  preferences  that  may  affect 
the  stocks,  and  the  condition  of  the  market  and  business  gen- 
erally. Quite  frequently  preferred  stock  is  issued  to  an  amount 
corresponding  roughly  in  value  to  the  cost  price  of  the  assets, 
while  the  common  stock  is  issued  on  the  presumption  that  it  will 
be  justified  by  future  development,  and  that  ultimately  the 
increased  earning  power  will  make  possible  the  payment  of  divi- 
dends thereon.  Sometimes  results  do  justify  the  act,  but  fre- 
quently they  do  not.  In  case  of  smaller  companies  it  is  usually 
best  to  issue  only  common  stock;  but  the  procedure  to  be  followed 
must  be  determined  upon  the  merits  of  the  individual  enterprise. 
Recently  the  directors  of  the  New  York,  New  Haven  &  Hartford 
Railroad  Company  considered  the  advisability  of  authorizing 
an  issue  of  preferred  stock,  the  company  having  only  common 
stock  outstanding.  Preferred  stock  in  this  case  would  probably 
afford  a  safer  means  of  obtaining  additional  funds  than  would 
bonds. 

Full  Paid  Stock. — Subscribers  to  the  stock  of  a  corporation 
may  make  payment  in  full  at  the  time  of  subscription,  or  later, 
or  they  may  make  their  payment  on  the  instalment  plan.  More- 
over, payment  may  be  made  in  cash,  in  property,  or  in  services 
performed.  When  payment  is  made  in  cash  there  arises  no 
question  as  to  the  value  given  for  the  stock.  When,  however, 
payment  is  made  in  property  or  services,  these  should  be  stated 
at  their  cash  value.  Should  they  be  over-valued  the  stock  ex- 
changed for  them  would  not  be  full-paid,  and  would  subject  the 
holder  to  the  possibility  of  having  to  make  it  full-paid  later  on. 
This  requirement  is  intended  for  the  protection  of  the  creditors, 
who  naturally  assume  that  the  stock  has  been  sold  for  its  full 
face  value  and  that  the  funds  so  received  are  invested  in  the  assets 
of  the  company. 

Bonded  Indebtedness. — Bonds  supplement  stock  as  a  means  of 
securing  capital  to  promote  the  corporation's  work.  Although 
there  are  many  corporations  which  have  no  outstanding  bonds 
whatever,  they  are  a  popular  and  useful  means  of  securing 
additional  funds.  The  issue  of  bonds  up  to  a  certain  point  is  a 
healthful  manifestation  of  business  activity;  although  the  over- 
issue of  bonds  is  acompanied  by  dangerous  possibilities.  Bonds 
are  to  corporations  what  mortgages  are  to  sole  proprietors  and 
partners,  and  differ  from  them  in  detail  more  than  in  principle. 
The  ordinary  mortgage  fails  to  secure  enough  capital  for  a  large 


152  ACCOUNTS  IN  THEORY  AND  PRACTICE 

concern  for  the  same  reason  that  a  partnership  fails  to  secure  it, 
viz.,  lack  of  appeal  to  a  sufficiently  wide  portion  of  the  investing 
public.  When  money  is  secured  upon  a  mortgage  the  entire  sum 
must  generally  be  secured  from  a  single  person  or  institution. 
Individuals  may  easily  be  found  who  are  willing  to  loan  sums 
mounting  up  into  the  thousands  of  dollars;  and  some  institutions, 
such  as  banks,  sometimes  loan  very  large  sums  of  money  to  com- 
panies which  provide  suitable  security.  Since,  however,  it  is 
not  the  province  of  banks  to  provide  capital  for  long  term  invest- 
ments, and  since  they  usually  wish  to  loan  on  security  other  than 
real  estate,  it  becomes  desirable  for  companies  possessing  exten- 
sive holdings  of  real  estate  to  find  some  suitable  plan  of  borrow- 
ing large  sums  of  money  upon  the  security  of  these  possessions. 

The  Deed  of  Trust. — The  difficulties  of  borrowing  suggested 
above  are  largely  obviated  by  the  use  of  bonds.  An  issue  of 
bonds  is  also  usually  accompanied  by  a  mortgage,  or,  as  it  is 
frequently  called,  a  deed  of  trust.  But  the  deed  of  trust,  not 
being  divisible,  and  not,  therefore,  being  capable  of  being  de- 
livered to  a  large  number  of  creditors,  is  deposited  with  a  trustee, 
usually  a  trust  company,  while  the  bonds,  which  are  issued  in 
denominations  of  $100,  $500,  or  $1000,  contain  a  sufficiently 
extended  reference  to  the  deed  of  trust  to  make  their  identity 
certain.  In  this  way  an  issue  of  say  $1,000,000  in  bonds  may  be 
scattered  among  scores  of  persons  all  dependent  ultimately  for 
protection  upon  a  single  mortgage  or  deed  of  trust.  Several 
considerations  serve  to  commend  this  arrangement.  In  the  first 
place,  it  would  be  extremely  awkward  to  issue  separate  mortages 
to  each  of  the  persons  who  might  care  to  become  investors  in 
the  bonds.  Then,  in  case  of  the  financial  embarrassment  of  the 
company,  there  would  be  many  creditors  hastening  to  foreclose 
their  mortgages  and  to  secure  their  share  of  the  spoils.  This  would 
make  united  and  strong  action  impossible.  When  a  single 
mortgage  is  placed  in  the  hands  of  a  trustee,  the  trustee  acts 
as  the  representative  of  all  the  bondholders  of  a  particular  issue, 
thus  securing  their  support  and  insuring  a  strong  and  united 
front. 

Stockholders  and  Bondholders  Compared. — The  chief  dis- 
tinction between  a  stockholder  and  a  bondholder  is  that  the 
stockholder  is  a  proprietor  while  the  bondholder  is  a  creditor. 
The  stockholder  receives  dividends  only  when  profits  are  earned; 
nor  can  the  stockholder  compel  the  board  of  directors  to  declare 


THE  CORPORATION— SPECIAL  CONSIDERATION        153 

a  dividend  even  when  profits  exist  from  which  it  might  be  paid. 
The  declaration  of  a  dividend  is  a  question  of  policy.  The  pay- 
ment of  income  on  bonds,  which  is  called  interest,  is  a  question 
not  of  policy  but  of  necessity.  Dividends  may,  but  interest 
must,  be  paid.  If  the  corporation  cannot  pay  the  interest  on  its 
bonds,  or  if,  when  the  principal  of  the  bonds  falls  due,  it  cannot 
pay  that,  the  usual  procedure  is  foreclosure  of  the  trust  deed 
according  to  its  terms  and  the  sale  of  the  company's  assets  for 
the  satisfaction  of  the  creditors'  claims. 

Since,  from  the  character  of  their  lien,  bonds  must  be  satisfied 
before  stock,  it  is  natural  to  assume  that  they  are  safer  for  in- 
vestment purposes  than  are  stocks.  As  a  rule  this  is  true,  and 
within  a  given  corporation  it  appears  inevitable.  Nevertheless, 
the  bonds  of  some  companies  are  not  as  desirable  as  investments 
as  are  the  stocks  of  other  companies,  so  that  the  question  of 
safety  is  entirely  relative. 

Variations  in  Bonds. — Bonds  differ  widely  in  the  character 
of  the  assets  upon  which  they  are  a  lien,  in  the  interest  they  bear, 
in  the  time  they  run,  and  in  the  method  by  which  they  are  ulti- 
mately redeemed.  To  discuss  these  qualities  here  is  beyond  our 
purpose. 

Advisability  of  Issuing  Bonds. — Bonds  may  be  issued  largely 
as  a  matter  of  necessity  after  the  possibilities  of  stock  issues  are 
exhausted.  Usually,  however,  their  issue  is  a  matter  of  policy. 
If  money  can  be  borrowed  at  5%  and  so  invested  as  to  yield 
10%,  the  transaction  is  a  profitable  one.  Such  procedure  is 
known  as  trading  on  the  equity.  The  question  which  a  corpora- 
tion is  frequently  compelled  to  answer  is,  whether  it  is  better 
to  continue  with  present  facilities  which  are  inadequate  to  secure 
the  best  results,  or  to  issue  bonds  and  thus  secure  funds  needed  to 
bring  the  plant  to  the  highest  state  of  efficiency.  If  money  thus 
borrowed  can  be  invested  so  that  it  will  return  an  income  well 
above  the  interest  paid  for  it,  the  stockholders  will  reap  larger 
dividends  without  having  invested  any  additional  capital  of 
their  own. 

Accounting  for  Stock  and  Bond  Issues. — The  books  of  a 
corporation  provide  adequate  records  for  the  issue  and  transfer 
of  stocks  and  bonds,  and  for  the  payment  of  dividends  and 
interest  thereon.  All  facts  in  connection  with  each  issue  must 
be  clearly  and  indisputably  stated.  If  bonds  are  sold  below  or 
above  par,  this  must  be  indicated,  and  the  premium  or  discount 


164  ACCOUNTS  IN  THEORY  AND  PRACTICE 

must  be  taken  into  consideration.  As  interest  accrues  from 
month  to  month  its  effect  upon  profits  must  be  carefully  shown. 
Any  actions  of  the  board  of  directors  definitely  affecting  the  assets 
or  liabilities  of  the  company  must  be  shown  by  proper  entries  in 
the  books.  In  brief,  the  accounting  principles  already  learned 
must  be  applied  to  those  conditions  which  are  peculiar  to  corporate 
organization. 


CHAPTER  XXIV 
THE  CORPORATION— OPENING  CORPORATION  BOOKS 

Work  of  the  Promoter. — Before  a  corporation  can  be  organized 
it  must  be  promoted.  It  is  beyond  our  province  to  discuss  the 
work  of  the  promoter  here  except  to  say  that  it  is  his  duty  to 
present  the  prospective  enterprise  to  his  friends  or  to  the  pubhc 
in  order  to  secure  their  subscriptions  to  the  stock  of  the  new 
company.  When  enough  stock  has  been  subscribed  the  com- 
pany is  organized  and  the  subscriptions  become  contracts 
between  the  subscribers  and  the  corporation. 

The  Opening  Entry — Stock  Authorized. — As  soon  as  the  com- 
pany is  organized  the  books  of  account  should  be  opened  and 
entry  made  of  whatever  information  of  a  financial  character 
may  be  necessary  to  show  clearly  the  status  of  the  company. 
The  Minute  Book,  in  which  a  record  is  kept  of  all  proceedings 
at  the  meetings  of  the  stockholders  and  board  of  directors, 
may  be  consulted  in  order  to  obtain  whatever  information 
in  the  way  historical  development,  purposes,  etc.,  it  may  be 
desirable  to  incorporate  in  the  opening  Journal  entry.  Natur- 
ally the  only  assets  of  a  newly  organized  corporation  are  the 
subscriptions  to  its  stock,  and  its  only  liability  is  its  obligation  to 
the  subscribers  for  their  subscriptions.  The  opening  entry  should 
therefore  show  this  incipient  condition.  Sometimes,  however, 
it  is  not  merely  desirable  to  show  the  actual  amount  of  sub- 
scriptions secured  but  also  to  indicate  the  amount  of  capital 
stock  authorized  by  the  charter,  that  is,  the  full  amount  of  the 
stock  which  may  be  issued  without  securing  an  amendment  to 
the  charter.  If  the  amount  of  stock  authorized  is  to  be  made 
the  subject  of  a  formal  journal  entry,  then  this  entry  should 
precede  the  entry  of  the  actual  subscriptions.  If  it  is  not  thought 
desirable  to  show  the  amount  of  stock  authorized,  in  the  balance 
sheet,  then  its  amount  may  be  given  in  the  preliminary  state- 
ment which  it  is  customary  to  insert  on  the  first  page  of  the 
Journal — chiefly  for  explanatory  purposes.  In  this  case  the 
first  formal  entry  will  be  for  the  amount  of  stock  actually  sub- 
scribed. 

166 


166  ACCOUNTS  IN   THEORY  AND  PRACTICE 

Proceeding  on  the  assumption  that  the  authorized  stock  is 
to  be  journalized,  the  opening  paragraph  and  first  journal  entry 
should  appear  somewhat  as  follows : 

The  Brown^AUen  Company  organized  under  the  laws  of  the  State  of 
Connecticut,  for  the  purpose  of  engaging  in  the  retail  grocery  business, 
begins  operations  this  first  day  of  July,  1916,  with  an  authorized  Capital 
Stock  of  $100,000,  divided  into  One  Thousand  Shares  of  a  par  value  of 
One  Hundred  Dollars  ($100.00)  each. 

July  1 

Unissued  Stock $100,000.00 

To  Authorized  Stock $100,000. 00 

Being  the  total  authorized  stock  of  the 
Brown- Allen  Company. 

In  case  of  small  corporations  it  is  not  customary  to  have  more 
than  one  kind  of  stock,  hence  it  is  all  common.  If,  as  is  fre- 
quently done  among  larger  enterprises,  permission  is  secured 
to  issue  both  common  and  preferred  stock,  the  journal  entry 
required  is: 

Unissued  Common  Stock 

Unissued  Preferred  Stock 

To  Authorized  Common  Stock 

Authorized  Preferred  Stock ....  

Being  the  total  authorized  stock,  pre- 
ferred and  common,  of  the  Company. 

The  Opening  Entry — Stock  Subscribed. — As  explained,  the 
above  entries  may  be  omitted,  being  more  or  less  a  matter  of  form. 
Their  presence  in  the  journal  neither  hinders  nor  makes  easier 
the  entries  which  follow.  The  first  essential  entry  is  that  which 
brings  into  the  books  a  record  of  the  liability  of  the  subscribers 
on  the  stock  which  they  agree  to  purchase.  The  general  form 
of  this  entry  is  as  follows : 

(a)  When  the  preceding  entry,  showing  the  amount  authorized, 
is  made: 

Subscribers  (or  Subscriptions) $85,000 .  00 

To  Unissued  Stock $85,000.00 

To  enter  upon  the  records  the  liabilities  of  the 
sundry  subscribers  to  the  stock  of  this  com- 
pany, as  per  the  following  schedule ; 

A.  R.  Brown 450  shares 

L.  M.  Allen 300  shares 

R,  T.  F*rince 50  shares 

L.  O.  Gordon 40  shares 

O.  S.  Smith 10  shares 


X" 


THE  CORPORA  TION— OPENING  CORPORA  TION  BOOKS    1 57 

If  there  are  both  common  and  preferred  stock  subscriptions, 
the  entry,  which  should  be  followed  by  suitable  explanations, 
the  names  of  the  subscribers  and  the  amount  and  kind  of 
stock  subscribed  by  each,  is : 

Subscribers  to  Common  Stock 

Subscribers  to  Preferred  Stock 

To  Unissued  Common  Stock ...  

Unissued  Preferred  Stock 

(b)  When  no  formal  journal  entry  is  made  to  record  the  amount 
of  stock  authorized: 

Subscribers  (or  Subscriptions) 

To  Capital  Stock 

(Explanation  as  in  (o)  above.) 

Payment  of  Subscriptions. — Before  the  corporation  can  begin 
operations  it  must  in  some  way  secure  the  cash  and  other  working 
and  fixed  assets  which  are  necessary.  Naturally  these  will  be 
provided  by  the  subscribers  to  the  capital  stock,  for  they  are 
to  become  the  proprietors  of  the  company.  They  can  provide 
the  necessary  assets  by  paying  their  subscriptions  to  the  capital 
stock  of  the  company.  Subscriptions  to  capital  stock  may  be 
paid  in  cash,  property  or  services.  The  simplest  procedure 
possible  would  be  to  have  all  subscribers  pay  the  full  amount  of 
their  subscriptions,  at  one  time,  and  in  cash  only.  If  the  various 
subscribers  to  the  stock  of  the  Brown- Allen  Company  should  make 
one  cash  payment  in  full  for  their  liability  on  their  subscriptions, 
this  transaction  could  be  journalized  thus: 

Cash $75,000.00 

To  Subscribers $75,000.00 

To  record  the  payment  in  full  for  their  sub- 
scriptions to  the  stock  of  the  Brown-Allen 
Company,  of  the  following:  (Names  of  sub- 
scribers and  number  of  shares  bought  by 
each). 

Payments  other  than  Cash. — In  many  instances  it  s  not  in- 
tended to  have  all  or  even  a  major  portion  of  the  stock  subscrip- 
tions paid  in  cash.  Frequently  corporations  are  organized  to 
take  over  enterprises  which  have  been  established  under  partner- 
ship organization.  In  such  cases  it  is  almost  always  the  desire 
and  intention  of  the  partners  to  pay  for  their  subscriptions  to  the 


158  ACCOUNTS  IN  THEORY  AND  PRACTICE 

stock  of  the  new  company  by  transferring  to  it  their  partnership 
interest  in  the  old  firm.  Usually,  too,  it  is  good  policy  to  pay 
some  of  the  expenses  incident  to  promotion  and  organization 
by  means  of  stock.  This  is  a  legitimate  procedure  since  pro- 
motion and  organization  expenses,  unlike  the  expenses  of  operation, 
are  looked  upon  as  investments  and  become  a  portion  of  the 
assets  of  the  company.  Where,  therefore,  property  or  services 
are  received  in  payment  of  stock  subscriptions  these  must  be 
charged,  instead  of  cash,  and  the  subscribers'  account  credited. 

Payments  in  Instalments. — Sometimes,  especially  in  the  case 
of  those  who  agree  to  pay  for  their  subscriptions  in  cash,  it  is 
not  desirable,  either  from  the  standpoint  of  the  company  or  the 
subscribers,  to  require  the  immediate  payment  of  the  full  amount 
of  the  subscriptions.  Not  only  do  subscribers  find  it  more  con- 
venient to  pay  in  instalments,  but  the  company  does  not  usually 
need  all  the  cash  at  once.  Hence  the  payments  are  usually 
made,  in  part  when  the  company  commences  operations,  and 
the  balance  in  a  given  number  of  instalments.  If  the  subscribers 
to  the  stock  of  the  Brown- Allen  Company  agree  to  make  payment 
in  four  instalments,  one  when  operations  are  begun  and  the 
balance  in  three  equal  monthly  payments,  the  following  entry 
will  be  sufficient  to  make  formal  record  of  the  agreement : 

Instalment  Number  1 

Instalment  Number  2 

Instalment  Number  3. . . , 

Instalment  Number  4 

To  Subscribers 

To  charge  instalments  Nos.  1,  2,  3  and  4,  due 

respectively  on  the  day  when  the  Brow  -Allen 

Company  begins  operations,  and  on  the  same 

day  of  the  three  succeeding  months. 

As  the  instalments  fall  due  cash  account  or  other  proper  ac- 
count is  charged  and  the  instalment  account  is  credited.  Thus,  if 
Instalment  Number  1  is  paid  in  cash,  the  entry  is: 

Cash $17,500 .  00 

To  Instalment  Number  1   $17.500 .  00 

Similar  entries  must  be  made  for  succeeding  instalments  as  they 
fall  due  and  are  paid. 


CHAPTER  XXV 

PROPRIETORSHIP  AND  PARTNERSHIP 
INCORPORATED 

As  has  been  noted,  corporations  are  frequently  organized  to 
continue  a  business  hitherto  run  by  a  sole  proprietor  or  by 
partners.  When  this  is  the  situation  the  assets  owned  by  the 
individual  proprietor  or  by  the  partners  become  the  assets, 
or  at  least  a  portion  of  the  assets  of  the  corporation.  The  cor- 
poration in  turn  assumes  the  debts  of  the  organization  which  it 
supplants.  This  is  oftentimes  the  plan  followed  by  individuals 
and  partners  who  do  not  possess  the  requisite  amount  of  capital 
to  make  needed  improvements  or  extensions,  and  who  can,  by 
this  agency,  appeal  to  a  large  number  of  investors. 

Valuation  of  Assets. — When  this  is  done  it  is  necessary  for  the 
proprietor  or  partners  to  determine  what  valuation  they  wish  to 
place  on  their  business  when  transferring  it  to  the  corporation, 
for  they  will  desire  to  obtain  their  fair  proportion  of  interest 
in  this  organization.  Probably  the  real  estate,  fixtures,  stocks 
of  goods,  and  so  on,  have  been  kept  on  the  books  at  cost  price 
less  whatever  deductions  may  have  been  allowed  for  depreciation, 
bad  debts,  etc.  Perhaps  the  owners  will  not  be  content  to  transfer 
their  assets  to  the  corporation  without  receiving  some  considera- 
tion for  the  goodwill  which  they  have  created  through  their 
diligence  and  industry.  It  is  even  possible,  though  it  may  not  be 
probable,  that  the  goodwill  may  exceed  in  value  all  of  the  tangible 
assets.  On  the  other  hand  goodwill  may  be  overvalued  with 
less  likelihood  of  the  overvaluation  being  detected  than  in 
case  of  tangible  assets.  Consequently  the  valuation  of  the  assets 
preparatory  to  their  exchange  for  the  stock  of  the  corporation 
should  seriously  engage  the  attention  of  the  old  proprietors. 

If  the  proprietors  place  too  great  a  valuation  upon  their  in- 
terests their  action  will  operate  against  the  future  welfare  of  the 
company  by  making  difficult  the  disposition  of  the  stock  to 
others.  The  solution  of  the  question  may  perhaps  best  be  found 
by  using  as  a  basis  for  estimating  the  value  of  goodwill  the  earning 
power  of  the  old  organization  and  the  probable  earning  power  of 
the  new  one.  If  the  old  organization  earns  15%  on  the  capital 
of  its  proprietors  and  if  the  investing  public  are  securing,  say  6%, 

159 


160  ACCOUNTS  IN  THEORY  AND  PRACTICE 

on  money  which  they  invest  in  stocks  of  companies  doing  a 
similar  kind  of  business  and  affording  about  the  same  degree 
of  security,  then  the  difference  between  15  and  6,  or  9%,  repre- 
sents roughly  the  earning  power  of  the  goodwill.  If,  for  example, 
the  profits  of  a  partnership  amount  to  $15,000  on  the  partners' 
combined  capital  account?  of  $100,000,  then  $15,000  capitalized 
on  a  6%  basis  gives  $250,000  as  the  real  value  of  the  partners' 
interests.  The  difference  between  $250,000  and  $100,000, 
or  $150,000,  represents  the  value  of  the  partners'  goodwill. 

The  above  is  an  assumption;  yet  in  practice  some  such  plan 
of  valuing  goodwill  is  pursued.  There  may  be  reason  to  believe 
that  under  the  corporate  form  of  organization,  with  more  capital 
invested,  wider  markets,  etc.,  the  earning  power  of  each  dollar 
invested  will  be  greater  than  before.  If  so,  the  partners  may  be 
justified  in  increasing  the  valuation  o^  the  goodwill  to  an  even 
greater  figure.  Experience  shows,  however,  that  the  anticipft- 
tions  of  greatly  increased  profits,  under  the  conditions  suggested, 
are  frequently  over-optimistic. 

Statement  of  Assets  and  Liabilities. — When  the  time  arrives 
to  make  the  transfer  of  the  partnership  or  proprietary  interests 
to  the  company,  an  accurate  statement  of  the  assets  and  liabilities 
to  be  transferred  should  be  made.  If  the  accounts  have  been 
properly  kept  the  closing  balance  sheet  of  the  old  concern  will 
afford  the  necessary  information.  This  statement  is  now  used 
as  a  basis  for  closing  the  books  of  the  old  enterprise  and  for 
bringing  into  the  corporation's  books  the  assets  which  it  receives 
and  the  liabilities  which  it  assumes. 

Goodwill. — Before  the  closing  entries  can  be  made  in  the  old 
books,  however,  an  account  must  be  opened  in  them  for  goodwill, 
if  it  is  to  be  sold.  This  goodwill  account  is  then  charged  with 
an  amount  which,  found  by  some  such  method  as  we  have  already 
suggested,  is  deemed  proper,  and  a  corresponding  credit  is  made 
in  the  one  or  more  capital  accounts.  To  illustrate,  assume 
that  the  firm  of  Brown  and  Allen,  before  goodwill  is  brought  into 
its  books,  has  assets  and  liabilities  as  shown  in  the  following 
balance  sheet: 

Balance  Sheet,  Brown  and  Allen : 

Real  Estate $27,000         Brown,  Capital $30,000 

Merchandise 6,000         Allen,  Capital 20,000 

Accounts  Receivable 16,000         Accounts  Payable. ......         6,000 

Cash. .  .• 7,000  

$56,000  $56,000 


PROPRIETORSHIP  AND  PARTNERSHIP  INCORPORATED        161 

If  Brown  and  Allen  conclude  that  their  profits  justify  them  in 
placing  a  valuation  of  $25,000  on  their  goodwill,  the  following 
journal  entry  will  serve  to  charge  goodwill  and  credit  their  re- 
spective capital  accounts,  which  we  assume  are  to  be  credited  in 
proportion  to  their  respective  interests : 

Goodwill $25,000.00 

To  Brown,  Capital $15,000.00 

Allen,  Capital 10,000 .  00 

After  these  entries  are  posted  a  balance  sheet  will  show : 

Balance  Sheet,  Brown  and  Allen: 

Real  Estate $27,000  Brown,  Capital $45,000 

Goodwill 25,000  Allen,    Capital 30,000 

Merchandise 6,000  Accounts  Payable 6,000 

;^counts  Receivable 16,000 

Cash 7,000 


$81,000  $81,000 

The  balance  sheet  now  presents  the  net  worth  at  the  figure 
at  which  the  partners  are  willing  to  exhange  it  for  the  stock  of  the 
corporation,  which,  let  us  assume,  will  continue  the  business 
under  the  title.  The  Brown-Allen  Company.  This  title  will 
preserve  to  the  corporation  whatever  goodwill  attaches  to  the 
names  of  the  partners,  while  the  latter,  owing  to  their  large  interest 
in  the  corporation,  are  likely  to  become  directors  or  officers. 

Factors  Determining  Capitalization. — Before  proceeding  with 
the  entries  required  to  close  the  partners'  accounts,  and  all  other 
accounts  in  the  old  books,  providing  new  books  are  to  be  in- 
stalled, let  us  consider  the  factors  which  will  determine  the  capi- 
talization of  the  corporation.  Two  prime  considerations  are  (a) 
present  requirements  and  (6)  future  requirements.  Allowance 
must  be  made  for  both  of  these  when  determining  what  shall  be 
the  capitalization.  Authorized  capital  must  be  sufficiently  large 
to  permit  all  desirable  expansion.  On  the  other  hand  if  made 
unnecessarily  large  it  will  cause  the  taxes  which  the  state  levies  on 
the  authorized  stock  to  become  an  unnecessary  burden.  Prob- 
ably the  partners  will  desire  to  control  securely  the  corporation 
by  becoming  owners  of  a  majority  not  only  of  all  issued  stock  but 
of  all  issuable  stock  as  well.  This  they  can  do  by  fixing  the  capi- 
talization of  the  corporation  at  such  a  figure  that  their  original 
11 


162  ACCOUNTS  IN  THEORY  AND  PRACTICE 

purchase  of  stock  will  give  them  such  controlling  interest. 
We  must  not  forget,  however,  that  the  chief  factor  to  be  con- 
sidered in  determining  the  proper  amount  at  which  to  capitalize 
is  the  need  for  funds,  present  and  future. 

In  the  example  we  have  assumed  that  $100,000  would  appear  to 
be  a  reasonable  authorized  capitalization.  Since  Brown  and 
Allen  are  to  receive  together  $75,000  of  the  stock  they  will  control 
the  corporation,  while  there  will  remain  $25,000  authorized  stock 
which  may  be  sold  when  desirable.  Furthermore,  we  assume 
that  only  common  stock  will  be  authorized.  In  addition  to  the 
stock  subscribed  by  Brown  and  Allen,  R.  T.  Prince  subscribes 
for  50  shares,  L.  0.  Gordon,  40  shares,  and  0.  S.  Smith,  10  shares, 
to  be  paid  in  cash  in  four  equal  instalments,  the  first  when  the 
company  begins  operations  and  the  remaining  three  at  intervals 
of  one,  two  and  three  months,  respectively,  thereafter. 

Entries  Necessary  to  Record  Changes. — The  opening  entry 
in  the  journal  of  the  corporation  will  now  be  the  same  as  shown 
on  page  156,  with  some  possible  variations  in  the  introductory 
paragraph,  mentioning  the  purposes  of  the  corporation,  and 
going  into  whatever  detail  may  be  necessary  to  state  fully  the 
conditions  under  which  the  purchase  of  the  business  of  Brown  and 
Allen  is  made.  Either  of  the  two  methods  described  on  page  156, 
may  be  pursued,  accordingly  as  it  is  desired  to  have  both  the 
authorized  and  the  issued  stock  shown  in  the  balance  sheet,  or 
merely  the  amount  of  stock  issued.  If  method  (a)  is  followed 
the  full  amount  of  the  authorized  stock  will  be  shown  in  the 
ledger  and  consequently  in  the  balance  sheet.  If  method  (6) 
is  followed  only  the  actual  stock  outstanding  will  be  shown. 

Since  the  subscription  of  the  firm  of  Brown  and  Allen  will  be 
paid  in  full  when  its  assets  and  liabilities  are  transferred  to  the 
Brown-Allen  Company,  while  the  other  subscriptions  will  be 
paid  in  instalments,  it  will  be  well  to  make  separate  entries  for 
these  two  classes  of  subscriptions.  The  entry  necessary  to  show 
the  four  instalments  is:^ 

Instalment  Number  1 $2,500.00 

Instalment  Nimiber  2 2,500 .  00 

Instalment  Number  3 2,500 .  00 

Instalment  Number  4 2,500 . 00 

To  Subscribers $10,000.00 

1  A  variation  from  this  procedure  is  to  charge  each  instalment  and  credit 
subscribers  account  as  each  instalment  falls  due  and  is  paid. 


PROPRIETORSHIP  AND  PARTNERSHIP  INCORPORATED       163 

Old  Books  Continued. — Suitable  explanation  should  follow 
this  entry,  stating  the  time  when  the  instalments  fall  due  and 
giving  any  other  information  the  circumstances  may  make 
desirable.  The  entries  necessary  to  bring  into  the  company's 
books  the  assets  and  liabilities  of  the  firm  of  Brown  and  Allen 
will  vary  according  to  conditions.  If  the  old  books  of  Brown 
and  Allen  are  to  be  closed  and  a  new  set  of  books  opened  for 
the  Brown-Allen  Company  a  different  procedure  will  be  required 
than  if  the  old  books  are  to  be  continued.  In  the  former  case 
all  of  the  accounts  in  the  old  books  will  be  closed  and  new 
accounts  will  be  opened  in  the  new  ledger  of  the  Brown-Allen 
Company  for  the  sundry  assets  purchased  and  liabilities  as- 
sumed. In  the  latter  case  only  the  partners'  capital  accounts 
will  be  closed  in  the  old  ledger  and  such  new  accounts  opened  as 
are  peculiar  to  corporation  accounting.  As  the  retention  of  the  old 
books  requires  the  simpler  procedure  let  us  first  consider  the  adjust- 
ments necessary  when  they  are  continued  by  the  corporation. 

When  Brown  and  Allen  subscribed  to  the  stock  of  the  Brown- 
Allen  Company  they  were  charged  as  subscribers  in  the  journal. 
Since  the  capital  accounts  of  Brown  and  Allen,  respectively,  are 
the  same  in  amount  as  their  subscriptions,  and  since  their  interest 
in  the  old  concern  is  measured  by  their  capital  accounts,  the 
following  entry  will  close  their  individual  capital  accounts,  and 
at  the  same  time  cancel  their  liability  as  subscribers : 

Capital,  Brown $45,000 .  00 

Capital,  Allen 30,000.00 

To  Subscribers $75,000.00 

The  Subscribers  Account  in  the  ledger  should  now  appear  thus: 

Subscribers  Account 

To  Unissued  Stock $85,000        By  Instalment  No.  1 $  2,500 

By  Instalment  No.  2 2,500 

By  Instalment  No.  3  ....  2,500 

By  Instalment  No.  4 2, .500 

By  Capital,  Brown 45,000 

By  Capital,  Allen 3,000 

$85,000  $85,000 


The  subscriptions  remaining  unpaid  at  any  time  are  shown  by 
the  debit  balances  of  the  Instalments  Accounts. 

New  Books  Opened. — If  new  books  are  installed  for  the  cor- 
poration it  will  be  necessary  to  close  not  only  the  partners' 


164  ACCOUNTS  IN  THEORY  AND  PRACTICE 

accounts  in  the  old  books,  but  all  others  as  well.  At  the  same 
time  that  the  asset  and  liability  accounts  in  the  old  books  are 
closed  they  are  opened  in  the  new  books  of  the  corporation.  In 
the  partnership  books  the  Brown- Allen  Company  is  charged  with 
the  value  of  the  assets  which  are  to  be  turned  over  to  it  and 
credited  with  the  amount  of  the  liabilities  which  it  is  to  assume, 
thus: 

Journal,  Brown  and  Allen 

The  Brown-Allen  Company $81,000.00 

To  Real  Estate $27,000.00 

Goodwill 25,000.00 

Merchandise 6,000.00 

Accounts  Receivable  16,000.00 

Cash 7,000.00 

To  charge  The  Brown- Allen  Company  for 
the  value  of  the  assets  of  the  firm  of  Brown 
and  Allen,  according  to  the  conditions  of  the 
agreement  made  between  the  firm  of  Brown 
and  Allen  and  the  Brown-Allen  Company, 
which  latter  is  to  receive  the  assets  and 
assume  the  liabilities  of  the  firm  of  Brown  and 
Allen. 

Accounts  Payable $6,000.00 

To  The  Brown-Allen  Company 6,000.00 

To  credit  The  Brown- Allen  Company  with 
the  liabilities  of  the  firm  of  Brown  and  Allen, 
these  accounts  being  assumed  by  the  Brown-         ' 
Allen  Company  as  per  agreement. 

As  a  result  of  the  above  entries  the  Brown- Allen  Company 
is  charged  in  the  books  of  Brown  and  Allen  with  the  net  amount 
of  $75,000,  the  gross  charge  of  $81,000  being  offset  to  the  extent 
of  $6,000,  the  credit  for  liabilities  assumed.  As  $75,000  is  also 
the  amount  of  the  stock  of  the  Brown-Allen  Company  subscribed 
by  Brown  and  Allen,  upon  receipt  of  the  stock  by  Brown  and  Al- 
len the  following  journal  entry  is  made: 

Capital  Stock  of  the  Brown- Allen  Company $75,000 .  00 

To  The  Brown- Allen  Company $75,000 .  00 

To  charge  the  capital  stock  of  The  Brown- Allen 
Company  for  the  amount  received,  $75,000,  this 
being  the  consideration  for  which  Brown  and  Allen 
agree  to  sell  their  interests  to  The  Brown- Allen 
Company. 

The  only  accounts  now  remaining  open  on  the  books  of  Brown 
and  Allen  are: 


PROPRIETORSHIP  AND  PARTNERSHIP  INCORPORATED       165 

Capital  Stock  of  The  Brown- Allen  Company  .  .  .      charged  with  $75,000 .  00 

Capital,  Brown credited  with    45,000 .  00 

Capital,  Allen credited  with    30,000.00 

When  the  stock  is  transferred  to  Brown  and  Allen,  respectively, 
as  individuals,  the  following  entry  is  required  to  close  their 
capital  accounts  as  well  as  the  account  with  the  stock  of  the 
Brown- Allen  Company: 

Capital,  Brown $45,000.00 

Capital,  Allen 30,000.00 

To  Capital  Stock  of  The  Brown- Allen  Co $75,000 .  00 

In  the  books  of  the  Brown-Allen  Company  entry  must  be 
made  to  charge  the  assets  taken  over  from  Brown  and  Allen 
as  well  as  to  credit  the  liabilities  assumed.  This  is  accomplished 
thus: 

Journal,  the  Brown-Allen  Company 

Real  Estate $27,000.00 

Goodwill 25,000.00 

Merchandise 6,000.00 

Accounts  Receivable ' 16,000.00 

Cash 7,000.00 

To  Subscribers $75,000 .  00 

Accounts  Payable .  6,000 .  00 

To  charge  the  assets  purchased  from  the 
firm  of  Brown  and  Allen,  and  to  credit  the 
liabilities  of  Brown  and  Allen  which  are 
assumed,  also  to  credit  Subscribers  Account 
with  the  excess  of  assets  purchased  over 
liabilities  assumed. 

The  Trial  Balance. — After  the  above  entries  in  the  journal  of 
the  Brown-Allen  Company  are  posted  to  the  ledger  a  trial  balance 
(not  essential,  but  desirable  to  prove  the  correctness  of  the  work) 
appears  thus: 

Trial  Balance,  the  Brown-Allen  Company : 

Instalment  No.  1 $2,-500         Capital  Stock $85,000 

Instalment  No.  2 2,500         Accounts  Payable 6,000 

Instalment  No.  3 2,500 

Instalment  No.  4 2,500 

Real  Estate 27.000 

Goodwill 25,000 

Merchandise 6,000 

Accounts  Receivable 16,000 

Cash 7,000 

Sg  1,000  $91,000 


166  ACCOUNTS  IN   THEORY  AND  PRACTICE 

If  ledger  accounts  are  opened  for  Unissued  Stock  and  Au- 
thorized Stock,  the  trial  balance  will  appear  slightly  different.  In 
the  one  shown  above  Unissued  Stock  would  appear  charged 
with  S15  000  and  Authorized  Stock  would  show  a  credit  balance 
of  $100,000,  while  Capital  Stock,  $85,000,  would  not  appear  on 
the  credit  side. 

The  procedure  in  case  of  a  corporation  which  does  not  pur- 
chase an  established  business,  but  secures  funds  for  the  construc- 
tion of  its  plant,  etc.,  entirely  through  the  sale  of  stock  for  cash 
differs  only  in  detail  the  instalments  and  cash  being  charged  in 
place  of  the  real  estate,  merchandise,  etc.,  taken  over. 


CHAPTER  XXVI 
THE  CORPORATION— ACCOUNTING  FOR  BOND  ISSUES 

General  Considerations. — The  advisability  of  issuing  bonds 
was  discussed  in  Chapter  XXIII.  When  the  management  has 
determined  upon  an  issue  of  bonds  entries  must  be  made  re- 
cording the  transactions  incident  to  their  sale,  also,  later  on, 
to  record  interest  accruals  and  payments  thereon,  the  correct 
distribution  of  discount  on  the  bonds  when  they  are  sold  at  a 
discount,  and  the  premiums  on  the  bonds  when  they  are  sold 
at  a  premium.  The  specifications  of  the  deed  of  trust  for 
the  establishment  of  sinking  funds  for  the  ultimate  payment  of 
the  bonds  must  be  observed.  Money  placed  in  sinking  funds 
is  oftentimes  invested  in  interest-bearing  securities,  or  in  some 
other  form  of  profitable  investment.  All  facts  incident  to  the 
estabhshment  of  such  funds  must  be  recorded  and  careful  record 
kept  of  interest  earned  by  the  funds  and  of  its  disposition  ac- 
cording to  the  provisions  of  the  deed  of  trust. 

Marketing  Bonds. — The  price  at' which  a  corporation  is  able 
to  market  its  bonds  is  a  variable  dependent  on  several  factors. 
Among  the  things  which  determine  bond  prices  are  the  general 
credit  of  the  corporation,  the  protection  afforded  the  bonds  by 
the  provisions  of  the  deed  of  trust,  the  rate  of  interest  which  the 
bonds  bear,  as  well  as  business  conditions  generally  and  the 
situation  of  the  money  market  when  the  the  sale  is  made.  An 
old  and  firmly  established  company,  able  to  offer  abundant  pro- 
tection to  creditors,  might  readily  market  a  given  issue  of  its 
bonds,  bearing  5  per  cent  interest,  above  par,  i.e.,  above  the 
face  value  of  the  bonds.  A  new  and  untried  company,  on  the 
other  hand,  might  have  great  difficulty  in  marketing  a  similar 
issue  at  par.  Again,  when  money  is  scarce,  investors  shy, 
and  conditions  in  general  are  unfavorable,  the  most  firmly 
established  concern  may  find  it  impossible  to  market  bonds  at 
what  it  considers  a  reasonable  price.  Following  the  panic 
of  1907  many  of  our  large  industrial  and  transportation  cor- 
porations chose  to  issue  notes  running  only  a  few  years  rather 

167 


168  ACCOUNTS  IN   THEORY  AND  PRACTICE 

than  yoke  themselves  to  long  term  bonds  bearing  high  rates  of  in- 
terest. Such  recourse  to  short  term  securities  is  frequently 
had  in  the  expectation  that  the  near  future  will  bring  better 
opportunities  to  market  securities  having  a  long  term  to  run. 

Bonds  Sold  at  Par. — From  an  accounting  point  of  view,  the 
simplest  situation  is  that  which  occurs  when  bonds  are  sold  at  par. 
There  is  no  premium  or  discount,  since  the  cash  received  is 
equal  to  the  face  of  the  bonds.  Cash  is  charged  and  the  bond 
account  is  credited  as  follows: 

Cash ". 

To  Bonds 

To   charge   cash   and   credit   bonds  for   the 
amount  sold,  at  par. 

If  the  following  balance  sheet  of  The  Atlas  Company  indicates 
the  situation  before  the  sale  of  bonds 

Balance  Sheet,  The  Atlas  Company : 

Fixed  Assets $15,000         Capital  Stock $25,000 

Current  Assets  (including 

cash) 5,000         Accounts  Payable 5,000 

Goodwill 10,000  

$30,000  $30,000 

then  after  the  sale  at  par,  t)f  an  issue  of  bonds  amounting  to 
$10,000,  the  balance  sheet  appears  thus: 

Balance  Sheet,  The  Atlas  Company : 

Fixed  Assets $15,000  Capital  Stock $25,000 

Current  Assets  (including 

cash) 15,000  Bonds 10,000 

Goodwill 10,000  Accounts  Payable 5,000 

$40,000  $40,000 

Bonds  Sold  at  Discount  or  Premium. — When,  however,  the 
bonds  are  disposed  of  either  above  or  below  par,  as  is  very  likely 
to  happen,  the  situation  is  more  complicated.  If  sold  below 
par  the  amount  of  cash  received  is  less  than  the  par  value  of 
the  bonds.  The  difference  must  therefore  be  charged  to  some 
other  account.  This  account  is  usually  called  the  "discount 
on  bonds"  account.  If  we  assume  that  The  Atlas  Company 
markets  its  bonds  at  90  per  cent,  of  their  par  value,  thus  receiving 
$9,000  in  cash  instead  of  $10,000,  the  following  entry  is  made: 


THE  CORPORATION— ACCOUNTING  FOR  BOND  ISSUES         169 

Cash $9,000.00 

Discounl  on  Bonds $1,000-00 

To  Bonds $10,000.00 

The  balance  sheet  now  becomes: 

Balance  Sheet,  The  Atlas  Company : 

Fixed  Assets $15,000         Capital  Stock $25,000 

Current  Assets  (including 

cash) 14,000         Bonds 10,000 

Discount  on  Bonds 1,000         Accounts  Payable 5,000 

Goodwill 10,000  

$40,000  $40,000 


If,  on  the  contrary,  the  bonds  sell  at  a  premium  of  10  per  cent 
instead  of  a  discount,  the  following  entry  is  required  to  record  the 
sale : 

Cash $11,000.00 

To  Bonds $10,000. 00 

Premium  on  Bonds 1,000.00 

Effective  Interest  Rate — Bonds  Sold  at  Discount. — The  ac- 
counts thus  set  up  to  record  the  premium  and  discount  on  bond 
issues  deserve  careful  consideration.  First,  let  us  consider  the 
situation  where  bonds  are  sold  at  a  discount.  The  reasons  for 
such  a  situation  have  already  been  discussed.  Since  the  amount 
of  cash  received  when  bonds  are  sold  below  par  is  less  than  the 
par  value  of  the  bonds,  the  interest  rate  paid  on  the  par  of  the 
bonds  is  really  nominal  and  in  a  sense  fictitious.  The  real 
or  effective  interest  charge  is  found  by  adding  together  the 
actual  amount  paid  out  yearly  as  interest  and  such  a  portion 
of  the  $1,000  discount  on  bonds  as  one  year  is  a  part  of  the  whole 
number  of  years  the  issue  runs.  If  the  above  mentioned  issue 
of  bonds  runs  twenty  years  and  bears  the  nominal  rate  of  interest 
of  5%,  that  is,  5%  on  the  par  of  the  bonds,  then  the  effective  in- 
terest rate  is  ($500  +  1/20  of  $1,000)  -r-  $9,000,  or  6.11%  on 
$9,000,  which  is  $550.00  per  annum. 

Thus  to  find  the  effective  rate  of  interest  we  find  the  ratio 
of  the  cost  per  year  to  the  actual  amount  of  cash  received  for  the 
bonds  and  not  to  the  par  value  of  the  bonds.  In  this  instance 
the  actual  cash  received  is  $9,000.  Moreover,  it  is  clear  that 
the  interest  cost  per  annum  is  $500  (5%  of  $10,000)  plus  one- 
twentieth  of  the  discount  on  the  bonds,  which  is  $50  (1/20  of 
$1,000). 


170  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Recording  Interest  Charge. — As  most  progressive  concerns 
find  their  profit  and  loss  monthly  the  accounting  procedure 
required  to  bring  into  the  books  the  real  interest  charge  for  each 
month  is: 

Profit  and  Loss $45.83 

To  Interest  Accrued $41 .  67 

Discount  on  Bonds 4.16 

To  charge  Profit  and  Loss  with  the  month's  burden 
of  interest  accruing  on  bonds,  and  to  credit  Interest 
Accrued  with  the  nominal  rate  of  interest,  and  Dis- 
count on  Bonds  with  the  month's  proportion  of  that 
expense,  the  same  being  a  charge  to  Profit  and  Loss. 

Later  when  the  interest  falls  due  and  is  paid,  presumably 
at  the  end  of  a  six  month's  period,  Interest  Accrued  is  charged 
and  Cash  is  credited,  thus: 

Interest  Accrued $250 .  00 

To  Cash '  $250.00 

For  payment  of  interest  accrued  on  bonds  during 
six  months'  period  closed. 

Small  Discrepancies  in  Interest  Calculations. — Since,  in 
business  transactions,  it  is  not  customary  to  carry  figures  repre- 
senting dollars  beyond  the  second  decimal  point,  thus  rounding 
off  the  sum  to  the  nearest  cent,  some  slight  discrepancies  arise 
in  the  above  figures,  not  sufficiently  great,  however,  to  vitiate 
the  results  to  any  material  degree.  Thus  the  amount  credited 
each  month  to  Discount  on  Bonds,  if  multiphed  by  12,  the 
number  of  months  in  a  year,  and  in  turn  by  20,  the  number 
of  years  the  bonds  run,  should  give  a  product  of  1,000,  the 
original  amount  in  dollars  of  the  Discount  on  Bonds  account. 
But  $4.16  X  12  X  20  =  $998.40,  or  $1.60  less  than  it  should  be. 
If  $4.17  were  credited  monthly  to  Discount  on  Bonds,  then 
$4.17  X  12  X  20  =  $1,000.80,  which  shows  an  excess  of  $0.80. 
A  discrepancy  as  small  as  this  may  be  ignored  until  the  bonds 
mature  and  then  be  added  or  deducted  from  the  last  monthly 
credit  to  Discount  on  Bonds  account,  thus  closing  this  account. 

A  similar  discrepancy  will  exist  at  the  end  of  each  six  months' 
period  between  the  credit  balance  in  the  Interest  Accrued 
account,  which  will  be  6  X  $41.67,  or  $250.02,  and  the  actual 
amount  of  interest  paid,  $250.  Since  the  $0.02  represents  an 
excess  charge  to  Profit  and  Loss  it  may  be  credited  to  that  ac- 
count at  the  end  of  each  six  months,  thus: 


THE  CORPORATION— ACCOUNTING  FOR  BOND  ISSUES         171 

Interest  Accrued $250.02 

To  Cash $250.00 

Profit  and  Loss 0.02 

For  payment  of  accrued  interest  on  bonds,  and 
to  carry  excess  interest  charge  of  $0.02  to  Profit 
and  Loss. 

Similarly  when  the  bonds  mature,  any  slight  discrepancy  in  the 
balance  of  the  Discount  on  Bonds  account,  such  as  was  indicated 
above,  can  be  carried  to  Profit  and  Loss. 

Effective  Interest  Rate — Bonds  Sold  at  Premium. — When 
bonds  are  sold  at  a  premium  the  same  principles  apply  as  when 
they  are  sold  at  a  discount,  but  the  effective  rate  of  interest  is 
less  than  the  nominal  rate.  Suppose  that  the  issue  of  bonds  had 
sold  at  110  instead  of  90.     The  entry  recording  the  sale  follows: 

Cash $11,000. 00 

To  Bonds $10,000 .  00 

Premium  on  Bonds 1,000 .  00 

Full  explanation  here. 

The  nominal  rate  of  interest,  that  is,  the  rate  paid  on  the  par 
value  of  the  bonds,  is  5%.  But  the  actual  interest  cost  per  annum 
is  ($500-1/20  of  $1,000)  -r-  $11,000,  or  4.09%  reckoned  on  $11, 000, 
or  $450  per  year.  This  rate  of  interest  considers  two  factors 
which  the  nominal  rate,  5%,  ignores.  The  first  factor  is  the 
$11,000  actually  received  for  the  bonds;  the  second  factor  is  the 
premium  on  the  bonds,  of  which  1/20  should  be  written  off  each 
year  to  reduce  the  amount  of  interest  charged  to  Profit  and  Loss. 
The  entries  required  are  similar  to  those  given  above,  with  such 
alterations  as  may  be  seen  by  an  examination  of  the  following: 

Profit  and  Loss $37. 50 

Premium  on  Bonds 4.16 

To  Interest  Accrued $41 .  66 

To  charge  the  Profit  and  Loss  and  Premium  on 

Bonds  accounts  with  the  month's  portion  of  interest 

accrued,  and  to  credit  the  Interest  Accrued  account 

with  the  nominal  rate  of  interest. 

If  interest  is  paid  semiannually,  at  the  end  of  each  six  months' 
period,  Interest  Accrued  is  charged  and  Cash  is  credited  with 
$250,  as  shown  above.  Any  slight  discrepancy  existing  in  the 
Interest  Accrued  account  can  be  carried  to  Profit  and  Loss,  as 
already  explained. 


172  ACCOUNTS  IN   THEORY  AND  PRACTICE 

Premium  or  Discount  Affects  Profit  and  Loss. — From  the 
foregoing  discussion  we  see  that  if  either  a  bond  premium  or  a 
bond  discount  account  is  raised  on  the  books  when  bonds  are  sold 
at  other  than  par  value,  this  premium  or  discount  account  must 
be  considered  as  a  factor  aiding  in  the  determination  of  the  actual 
interest  charge  to  be  made  to  Profit  and  Loss.  If  the  bonds  sell 
at  a  discount,  the  amount  of  the  discount  should  be  prorated 
over  the  time  the  bonds  run,  the  amount  applicable  to  each  period 
being  added  to  the  actual  interest  paid,  i.e.,  the  nominal  interest, 
to  determine  the  amount  to  be  charged  to  Profit  and  Loss.  If  the 
bonds  sell  at  a  premium,  the  amount  of  the  premium  should  be 
prorated  over  the  life  of  the  bonds,  and  the  amount  apphcable 
to  each  period  should  be  subtracted  from  the  actual  interest  paid 
to  determine  the  amount  to  be  charged  as  interest  to  Profit  and 
Loss. 

When  bond  discount  and  premium  are  considered  in  connection 
with  redemption  prices  above  or  below  par,  or  when  the  situation 
is  complicated  by  the  redemption  of  bonds  before  the  date  of 
maturity,  comphcations  arise.  The  student  is  referred  to  works 
listed  on  page  183  for  a  discussion  of  these  questions. 


CHAPTER  XXVII 
THE  CORPORATION— REDEMPTION  OF  BONDS 

Redemption  of  Bonds. — An  issue  of  bonds  may  be  redeemed 
serially,  that  is,  a  given  number  of  the  outstanding  bonds  may  be 
drawn  each  year  by  lot  and  purchased  by  the  issuing  company, 
being  redeemed  at  par  or  some  other  figure.  On  the  other  hand, 
the  whole  issue  may  remain  outstanding  until  the  expiration  of 
the  period  prescribed  and  then  be  redeemed  in  toto.  Accordingly 
bonds  are  classified  as  serial  and  sinking  fund,  depending  upon  the 
mode  of  payment.  A  third  classification  includes  those  bonds 
which  are  issued  with  the  expectation,  not  of  paying  them  off,  but 
of  refunding  them,  when  the  time  over  which  they  run  expires. 
That  is,  new  bonds  are  issued  in  exchange  for  the  old  ones.  The 
advisability  of  issuing  a  given  kind  of  bonds  must  be  determined 
by  the  character  of  the  issuing  company  and  the  purpose  of  the 
issue. 

Bonds  Issued  in  Perpetuity. — We  have  learned  that  it  is  fre- 
quently of  advantage  to  a  company  to  trade  on  the  equity  of 
borrowed  funds.  Consequently  it  may  be  desirable  for  a  company 
to  establish  a  permanent  bonded  indebtedness,  within  certain 
limits.  This  being  true,  it  might  be  desirable  to  sell  bonds  not 
having  a  maturity  date  and  which,  therefore,  would  remain  the 
permanent  obligations  of  the  company.  This  plan  is  followed 
extensively  in  England,  but  in  the  United  States  it  has  not  been 
popular.  However,  some  of  our  corporations  have  issued  bonds 
maturing  at  such  a  distant  period  that  they  may  be  regarded  as 
perpetual  obligations,  for  practical  purposes.  When  interest 
rates  are  high,  as  they  tend  to  be  in  a  new  country  where  capital 
is  scarce,  short  term  issues  are  naturally  preferred  because  of  the 
expectation  that  interest  rates  will  be  lower  later  on. 

Sources  of  Redemption  Funds. — Whether  bonds  be  sinking 
fund  or  serial,  there  are  but  two  possible  sources  from  which  the 
means  for  their  redemption  can  be  secured,  viz.,  (a)  capital  and 
(6)  profits.  If  an  issue  of  bonds  amounting  to  $1,000,000  is  sold 
at  par  and  the  receipts  from  the  sale  invested  in  the  business,  the 
net  proprietorship  will  remain  the  same  or  be  increased  by  $1,000,- 

173 


174  ACCOUNTS  IN   THEORY  AND  PRACTICE 

000  accordingly  as  these  bonds  are  ultimately  redeemed  out  of 
capital  or  out  of  profits,  assuming  that  the  assets  purchased  with 
the  $1,000,000  are  preserved  at  their  original  value.  To  illustrate, 
let  us  assume  that  The  Royal  Manufacturing  Company,  before  the 
sale  of  $1,000,000  of  bonds,  has  the  following  balance  sheet: 

Balance  Sheet,  Royal  Manufacturing  Company : 

Fixed  Assets $2,000,000         Capital  Stock $2,000,000 

Accounts  Receivable. .  200,000         Accounts  Payable 310,000 

Cash 110,000  

$2,310,000  $2,310,000 

If  the  bonds  are  sold  at  par  and  the  returns  invested  in  land  or 
other  fixed  assets,  the  balance  sheet  becomes : 

Balance  Sheet,  Royal  Manufacturing  Company : 

Fixed  Assets $3,000,000         Capital  Stock $2,000,000 

Accounts  Receivable. .          200,000         Bonds 1,000,000 

Cash 110,000         Accounts  Payable...  310,000 

$3,310,000  $3,310,000 

If  the  bonds  run  ten  years,  then,  disregarding  interest,  it  will 
be  necessary  to  lay  aside  $100,000  each  year  for  ten  years  in  order, 
after  ten  years,  to  have  a  fund  of  $1,000,000  with  which  to  redeem 
the  bonds.  Where  shall  the  $100,000  be  secured  each  year? 
Shall  we  retain  that  much  of  the  profits  each  year  until  we  have 
saved  $1,000,000  profits?  Or  shall  we  wait  until  the  expiration 
of  ten  years,  meanwhile  distributing  profits  to  stockholders,  and 
then  use  whatever  available  assets  there  may  be  to  pay  off  the 
bonds?  If  we  reserve  $1,000,000  of  the  profits,  then  at  the  end  of 
ten  years,  but  before  the  bonds  are  redeemed,  the  balance  sheet 
will  appear  essentially  as  follows: 

Balance,  Sheet  Royal  Manufacturing  Company: 

Fixed  Assets $3,000,000        Capital  Stock $2,000,000 

Accounts  Receivable...          200,000         Bonds 1,000,000 

Cash 1,110,000         Accounts  Payable 310,000 

Profit  and  Loss 1,000,000 

$4.310,000  $4,310,000 

When  the  bonds  are  paid  the  following  entry  is  made: 

Bonds $1,000,000.00 

To  Cash $1,000,000.00 

after  which  the  balance  sheet  becomes: 


THE  CORPORATION— REDEMPTION  OF  BONDS         175 

Balance   Sheet,  Royal  Manufacturing  Company: 

Fixed  Assets $3,000,000  Capital  Stock $2,000,000 

Accounts  Receivable. .          200,000  Accounts  Payable. . .   .  310,000 

Cash 110,000  Profit  and  Loss 1,000,000 

$3,310,000  $3,310,000 


An  examination  of  this  balance  sheet  shows  that  whereas  the 
habilities  of  The  Royal  Manufacturing  Company  are  no  greater 
than  before  the  bonds  were  issued,  its  assets  have  increased  in 
value  $1,000,000.  This  is  due  to  the  fact  that  the  bonds  have 
been  paid  out  of  profits.  Had  no  profits  been  retained,  it  would 
have  been  necessary  to  convert  enough  of  the  fixed  assets  into 
cash  to  make  the  $1,000,000  required  for  the  payment.  If 
this  is  done  the  balance  sheet  appears  thus: 

Balance  Sheet,  Royal  Manufacturing  Company: 

Fixed  Assets $2,110,000  Capital  Stock $2,000,000 

Accounts  Receivable 200,000  Bonds 1,000,000 

Cash 110,000  Accounts  Payable. .  .  310,000 

$3,310,000  $3,310,000 

providing  the  conversion  of  fixed  assets  into  cash  is  made  without 
loss.  Then,  after  the  bonds  are  redeemed,  the  balance  sheet 
becomes : 

Balance  Sheet,  Royal  Manufacturing  Company : 

Fixed  Assets $2,110,000         Capital  Stock $2,000,000 

Accounts  Receivable 200,000         Accounts  Payable. .  310,000 

$2,310,000  $2,310.000 

which  leaves  the  company  with  assets  of  the  same  value  as  before 
the  bonds  were  issued — the  consequence  of  redeeming  bonds  out 
of  capital. 

Comparison  of  These  Plans. — Which  plan  is  best  to  follow 
circumstances  must  determine.  A  company  is  not  under  obli- 
gation to  use  profits  to  pay  bonds,  the  sale  of  which  is  made  to 
secure  purchase  money  for  permanent  additions  and  better- 
ments. But  while,  theoretically,  a  company  invests  the  re- 
turns from  bonds  in  assets  of  permanent  value,  it  frequently 
happens,  in  practice,  that  the  money  derived  from  bond  sales 
is  spent  for  improvements  the  value  of  which  is  by  no  means 
permanent.     Suppose  that  the  Royal  Manufacturing  Company 


176  ACCOUNTS  IN  THEORY  AND  PRACTICE 

invests  the  $1,000,000  secured  by  the  sale  of  bonds,  in  machinery 
possessing  a  useful  lifetime  of  ten  years.  Then,  if  no  reservations 
are  made  to  cover  depreciation,  the  balance  sheet,  after  the  bonds 
are  paid,  becomes: 

Balance  Sheet,  Royal  Manufacturing  Company : 

Fixed  Assets $1,110,000  Capital  Stock $2,000,000 

Accounts  Receivable. . . .  200,000  Accounts  Payable 310,000 

Deficit 1,000,000  

$27310^  $2,310,000 

Depreciation  a  Factor. — In  this  instance  $1,000,000  of  the 
capital  has  been  paid  out  as  dividends,  an  illegal  procedure  in 
most  cases  for  which  the  directors  of  the  company  may  be  held 
personally  responsible.  Had  proper  allowances  been  made  for 
depreciation  this  situation  would  not  have  arisen.  A  deprecia- 
tion reserve  would  have  been  set  up  on  the  credit  side  of  the  ledger 
and  credited  each  year  with,  say,  $100,000,  and  a  corresponding 
charge  made  to  Profit  and  Loss — with  the  result  that,  for  the 
ten  year  period,  a  showing  of  $1,000,000  less  in  profits  would 
have  been  made;  so  that  essentially  the  same  situation  would 
have  resulted  as  when  the  assets  do  not  depreciate  and  no  reserve 
for  depreciation  is  set  up.  In  reality,  of  course,  the  profits  are 
$1,000,000  less. 

These  illustrations  indicate  the  principles  to  be  followed  in 
determining  whether  a  sinking  fund  ought  to  be  set  aside  out  of 
profits  or  out  of  capital.  If  adequate  depreciation  allowances 
are  made  it  is  not  necessary  or  even  advisable,  as  a  rule,  to  adopt 
the   ultraconservative    policy   of  paying  bonds  out  of  profits. 

The  Sinking  Fund. — ^We  must  not  conclude  from  the  fore- 
going that  it  is  not  necessary  to  make  actual  cash  reservations 
for  the  sinking  fund,  which  is  an  altogether  different  matter. 
This  is  a  procedure  quite  independent  of  the  question  whether 
bonds  ought  to  be  redeemed  out  of  capital  or  out  of  profits.  If 
proper  depreciation  allowances  are  made,  or  if  profits  sufficient 
to  pay  off  the  bonds  are  retained,  the  presumption  is  that  cash 
will  be  forthcoming  to  make  the  payment  when  the  time  for  it 
arrives.  But  there  is  no  guaranty  that  this  will  be  the  case  other 
than  the  general  policy  of  the  management.  Usually  such  a 
guaranty  does  not  satisfy  the  requirements  of  investors. 

The  customary  procedure  is  to  require  the  company  that  issues 


THE  CORPORATION— REDEMPTION  OF  BONDS         177 

the  bonds  to  make  periodic  payments,  annual  or  otherwise,  to  a 
trustee,  whose  duty  it  is  to  invest  them  as  profitably  as  is  con- 
sistent with  security,  and  thus  to  hold  them  for  the  protection  of 
the  bondholders  as  well  as  for  the  ultimate  redemption  of  the 
bonds.  The  earnings  of  this  trust  fund  may  be  added  to  it,  or 
not,  according  to  arrangements.  If  the  earnings  are  turned 
back  into  the  fund  the  instalments  needed  to  bring  the  fund  to 
the  required  amount  in  a  given  time  are  smaller  than  if  the  earn- 
ings are  turned  over  into  the  general  fund  of  the  company.  If, 
to  illustrate,  we  ignore  interest  considerations,  it  will  require  ten 
yearly  instalments  of  $100,000  each  to  create  a  sinking  fund  of 
$1,000,000  in  ten  years.  The  following  entry  records  the  trans- 
fer of  the  periodic  instalment  to  the  trustee: 

Sinking  Fund  Trustee $100,000.00 

To  Cash $100,000.00 

To  record  payment  of  cash  to  the  trustee  accord- 
ing to  provisions  of  the  deed  of  trust. 

As  a  consequence  of  this  annual  transfer  of  cash  to  the  sinking 
fund  trustee  there  appears  on  the  balance  sheet  an  asset  account 
under  the  title.  Sinking  Fund,  which  after  ten  years  amounts 
to  $1,000,000  and  the  balance  sheet  becomes: 

Balance  Sheet,  Royal  Manufacturing  Company : 

Fixed  Assets $3,000,000  Capital  Stock  $2,000,000 

Accounts  Recievable.  .          200,000  Bonds 1,000.000 

Sinking  Fund  in  Hands  Accounts  Payable 310,000 

of  Trustee 1,000,000  Profit  and  Loss 1000,000 

Cash 110,000  

$4,310,000  $4,310,000 

When  the  bonds  are  redeemed  the  following  entry  is  made: 

Bonds $1,000,000.00 

To  Sinking  Fund $1,000,000.00 

which,  when  posted,  leaves  the  balance  sheet  as  shown  at  the 
top  of  page  175. 

Interest  on  Bonds. — Although  there  is  room  for  dispute  as  to 
the  proper  origin  of  funds  to  be  employed  in  payment  of  the  prin- 
cipal of  bonds  there  is  no  question  as  to  the  proper  source  of  the 
means  needed  to  satisfy  interest  requirements.     Interest  is  an 

12 


178  ACCOUNTS  IN  THEORY  AND  PRACTICE 

expense  which  must  be  paid  out  of  income,  not  out  of  capital.  It 
is  one  of  the  deductions  which  must  be  made  from  gross  income 
to  arrive  at  net  profits.  Since  interest  is  paid  annually  or  semi- 
annually, it  is  necessary,  when  closing  the  nominal  accounts  into 
Profit  and  Loss,  to  charge  Profit  and  Loss  with  the  period's 
proper  burden  of  interest,  even  though  it  be  not  yet  due.  Thus 
if  the  $1,000,000  issue  of  the  Royal  Manufacturing  Company 
bears  5%  interest,  payable  semiannually  on  June  30  and  De- 
cember 31,  and  if  an  income  statement  is  set  up  monthly,  each 
month's  interest  charge  must  be  entered  although  interest  is 
paid  only  twice  during  the  year.  One  month's  interest  at  5% 
on  $1,000,000  is  $4,166.67  The  following  entry  is  necessary 
to  charge  Profit  and  Loss  and  credit  the  liability  account.  In- 
terest Accrued. 

Interest , $4,166.67 

To  Interest  Accrued $4,166. 67 

Interest  is  in  turn  charged  to  Profit  and  Loss,  but  Interest 
Accrued  is  a  real  account  which  appears  in  the  balance  sheet 
for  January  31  as  a  current  liability.  Similarly,  each  month 
Profit  and  Loss  is  charged  with  the  month's  quota  of  interest  and 
the  Interest  Accrued  account  is  credited,  until  at  the  close  of 
the  half  year  Interest  Accrued  stands  credited  with  six  months' 
interest — $25,000,  which  is  then  due  and  payable.  When  paid 
the  following  entry  is  made: 

Interest  Accrued $25,000 .  00 

To  Cash $25,000. 00 

Thus  the  Interest  Accrued  account  is  closed,  and  the  current 
liability  which  has  been  accruing  for  six  months  is  liquidated. 
The  same  process  is  repeated  during  the  next  six  months,  and 
so  on.  » 

Interest  on  Sinking  Fund. — Interest  earned  by  the  sinking 
fund  may  be  (a)  added  to  the  fund,  or  (6)  turned  back  into  the 
business.  Entries  must  be  made  to  record  this  interest.  If  it 
is  added  to  the  sinking  fund  the  following  entry  is  made  monthly: 

Accrued  Income  on  Sinking  Fund 

To  Income  on  Sinking  Fund 

To  record  interest  accrued  during  the  month  ' 

on  sinking  fund  investments. 
When  the  sinking  fund  trustee  receives  cash  in  payment  of  the 
accrued  interest  on  the  sinking  fund  the  following  entry  is  made 


THE  CORPORATION— REDEMPTION  OF  BONDS  179 

Sinking  Fund  Trustee 

To  Accrued  Income  on  Sinking  Fund 

To  charge  with  cash  received  by  him  on  sink- 
ing fund  investments. 

If  the  sinking  fund  trustee  retains  the  interest  received  this 
entry  is  sufficient.  If  he  pays  it  over  to  the  company  cash  is 
charged  and  the  trustee  credited,  thus: 

Cash 

To  Sinking  Fund  Trustee 

To  credit  the  sinking  fund  trustee  with  the 
amount  of  interest  received  by  him  on  sinking 
fund  investments  and  now  paid  over  to  the 
company. 


CHAPTER  XXVIII 

THE  CORPORATION— ROUTINE  ACCOUNTING 
PROCEDURE 

Use  of  the  Surplus  Account. — In  general,  the  routine  procedure 
involved  in  corporation  accounting  is  not  different  from  that 
required  for  proprietorships  or  partners!,  i  ps.  The  chief  peculiari- 
ties in  corporate  procedure  are  the  result  of  the  method  employed 
to  indicate  proprietorship  and  to  show  the  disposition  of  profits. 
The  amount  of  the  capital  stock  i  fixed  by  the  charter  and  can- 
not be  readily  changed.  Moreover,  capital  stock  is  usually 
shown  at  par  in  the  accounts  while  its  real  value  may  be  either 
above  or  below  par  value.  Capital  is  constantly  changing  as 
the  result  of  the  losses  and  gains  incident  to  operations  while 
capital  stock  remains  stationary.  Therefore  it  becomes  neces- 
sary to  establish  an  account  whose  purpose  is  to  show  these 
changes  This  is  the  Surplus  or  Deficit  account,  accordingly  as 
capital  is  greater  or  less  than  the  amount  shown  by  the  Capital 
Stock  accounts — assuming  that  capital  stock  is  full  paid. 

In  case  of  sole  proprietorships  and  partnerships  it  is  customary 
to  carry  the  undistributed  part  of  net  profits  to  the  capital  ac- 
counts in  accordance  with  some  prescribed  procedure,  but  in 
corporation  accounting  separate  capital  accounts  are  not  kept 
or  the  stockholders.  In  place  of  these  capital  accounts  there  is 
the  Capital  Stock  account  (or  accounts)  which  is  sometimes  a 
controlhng  account  for  the  individual  stockho  ders'  accounts  kept 
in  the  subordinate  Stock  Ledger.  These  individual  accounts 
are  altered  only  when  stock  is  transferred  from  one  party  to 
another  or  when  new  stock  is  issued,  neither  of  which  transactions 
are  related  to  the  determination,  recording,  or  distribution  of 
profits. 

For  this  reason  it  is  necessary  to  carry  profits  to  a  Surplus 
account.  This  account  plays  a  significant  part  in  corporation 
accounting.  When  a  corporation  increases  its  surplus  by  bring- 
ing into  it  each  year  a  portion  of  the  current  profits  it  is  said  to 
pursue  a  conservative  policy,  while  one  which  accumulates  no 
surplus  is  not  likely  to  be  found  well  prepared  to  weather  a 

180 


ROUTINE  ACCOUNTING  PROCEDURE  181 

period  of  hard  times  Such  a  statement  is  a  mere  generahzation, 
however,  and  subject  to  many  quaUfications  and  Hmitations  in 
individual  instances.  The  amount  of  surplus  which  it  may  be 
desirable  to  accumulate  will  depend  upon  the  character  of  the 
enterprise  and  the  peculiar  conditions  surrounding  it. 

Surplus  Account  Illustrated. — Let  the  following  statement 
represent  the  condition  of  the  Smith-Ailing  Company  as  at  Dec. 
31,  1919: 

Balance  Sheet,  Smith-Ailing  Company,  as  at  Dec.  31,  1919 : 

Factory  Building $100,000     Capital  Stock $150,000 

Inventories 55,000     Other  Liabilities 12,000 

Current  Assets 12,000     Reserve  for  Depreciation, .         5,000 

$167,000  $167,000 


During  the  year  1920  various  operations  are  engaged  in,  result- 
ing in  a  net  profit  of  $10,000  which  is  carried  to  Surplus.  The 
balance  sheet  as  at  Dec.  31,  1920  is  as  follows: 

Balance  Sheet,  Smith-Ailing  Company,  as  at  Dec.  31,  1920: 

Factory  Building $100,000     Capital  Stock $150,000 

Inventories 60,000     Other  Liabilities 10,000 

Current  Assets 20,000     Reserve  for  Depreciation.  10,000 

Surplus 10,000 


$180,000  $180.000 

The  entry  by  which  net  profits  is  carried  to  Surplus  is: 

Profit  and  Loss $10,000 

To  Surplus $10,000 

To  carry  net  profit  for  the  year  ending 

Dec.  31, 1920,  to  the  Surplus  account  and 

to  close  the  Profit  and  Loss  account. 

Disposition  of  Surplus. — The  disposition  of  the  surplus  rests 
in  the  power  of  the  board  of  directors.  It  is  they  who  decide 
what  portion  of  it  shall  be  used  to  pay  dividends,  what  portion 
shall  be  retained  in  the  Surplus  account,  and  what  portions 
shall  be  set  up  as  special  reserves.  We  have  learned  that  re- 
serves are  of  twojcinds,  profit  and  valuation.  Reserves  estab- 
lished out  of  surplus  are  reseves  of  profit  because  they  represent 
value  over  and  above  the  original   investment.     Among  such 


182  ACCOUNTS  IN  THEORY  AND  PRACTICE 

special  reservations  are  those  made  to  finance  additions  and  bet- 
terments, to  meet  contingencies,  and  to  provide  for  the  liquidation 
of  bonded  indebtedness  out  of  profits. 

Sources  of  Surplus. — Surplus  does  not  always  represent  ac- 
cumulated profits,  however.  There  are  various  ways  in  which 
it  may  be  increased  or  diminished  other  than  through  profits  or 
losses  resulting  from  operations.  One  of  the  most  frequent  of 
these  is  by  the  sale  of  capital  stock  above  par.  Thus  if  100 
shares  of  capital  stock  having  a  par  value  of  $100  per  share  is 
sold  at  a  premium  of  10  we  have  the  following: 

Cash $11,000 

To  Capital  Stock $10,000 

Surplus 1,000 

To  record  sale  of  capital  stock  at  110,  the 
premium  being  credited  to  surplus. 

Evidently  surplus  which  originates  at  occasional  intervals  by 
sale  of  stock  above  par  or  as  the  result  of  other  more  or  less 
fortuitous  circumstances  should  be  distinguished  from  that  which 
represents  accumulated  profits.  This  has  led  in  some  instances 
to  a  subdivision  of  the  surplus  account  to  show  capital  surplus 
distinct  from  surplus  representing  accumulated  profits.  Note 
to  what  extent  the  surplus  account  prescribed  by  the  Interstate 
Commerce  Commission  for  railroad  companies  is  subdivided: 
Corporate  Surplus 

Additions  to  property  through  income  and  surplus. 

Funded  debt  retired  through  income  and  surplus. 

Sinking  fund  reserves. 

Miscellaneous  fund  reserves. 

Appropriated  surplus  not  specifically  invested. 

Total  appropriated  surplus. 
Profit  and  loss — Balance. 

Total  corporate  surplus. 

The  first  five  items  in-  this  statement  represent  appropriations 
of  surplus  for  specific  purposes.  The  first  four  represent  specific 
investments.  Unappropriated  surplus  is  represented  by  the 
balance  of  Profit  and  Loss.  By  combining  appropriated  and 
unappropriated  surplus  we  secure  total  corporate  surplus.  This 
arrangement  does  not  show  the  division  between  earned  and 
unearned  surplus,  however.  - 

That  surplus  arising  from  sale  of  capital  stock  at  a  premium 
should  be  segregated  will  appear  from  the  following  considera- 


ROUTINE  ACCOUNTING  PROCEDURE  183 

tions.  The  total  amount  received  for  a  share  of  stock  sold  at  a 
premium  represents  what  the  purchaser  considers  such  a  share 
to  be  worth.  It  in  no  way  represents  profits  but  is  rather  in  the 
nature  of  an  original  investment  of  capital.  To  employ  such 
surplus  for  purposes  of  paying  dividends  would  be  to  impair  the 
original  investment  and  therefore  reduce  the  value  of  outstanding 
stock. 

Dividends. — The  profits  accruing  to  a  corporation  may  be 
distributed  in  whole  or  in  part  to  the  stockholders  in  the  form  of 
dividends.  How  much  of  the  profits  shall  be  retained  to 
strengthen  the  concern  and  how  much  shall  be  distributed  is  a 
question  of  financial  policy  which  the  board  of  directors  must 
decide.  Banks  make  especially  large  reservations  of  profits,  so 
that  we  frequently  find  their  surplus  accounts  in  excess  of  their 
capital  stock  accounts. 

Dividend  Defined. — A  dividend  is  a  distribution  of  accumu- 
lated profit  among  a  given  class  of  stockholders.  If  but  one 
class  of  stock  is  outstanding  the  distribution  is  made  on  a  pro 
rata  basis  among  all  stockholders.  When,  however,  there  are 
two  or  more  classes  of  stock  outstanding  a  different  procedure 
may  be  followed  for  each  class.  Thus  if  there  are  preferred 
and  common  stocks,  and  the  preferred  is,  let  us  say,  6%  cumula- 
tive stock,  then  the  preferred  stock  dividend  must  be  paid  in 
full  before  anything  can  be  paid  on  the  common;  and  if  in  any 
given  year  the  profits  are  insufficient  to  pay  the  full  amount  of 
the  dividend  on  the  preferred  stock,  then  it  must  be  paid  in  the 
next  year,  or  later,  before  anything  can  be  paid  to  the  common 
stockholders. 

Kinds  of  Dividends. — Dividends  are  of  several  kinds  in  accord- 
ance with  the  medium  of  payment.  Cash  dividends  are  most 
frequent  and  consist  in  payment  by  check,  or,  in  exceptional 
cases,  actual  cash.  Scrip  dividends  are  paid  in  the  form  of 
promissory  notes  of  the  company,  which  are  at  a  later  period  re- 
deemable in  cash  or  other  form  of  property.  Stock  dividends 
are  paid  by  issuing  capital  stock,  either  treasury  or  unissued,  in 
payment.  Other  forms  less  frequently  used  are  property  and 
bond  dividends,  the  former  being  paid  by  an  actual  distribution 
of  property  and  the  latter  by  is.suing  bonds. 

Declaration  of  Dividends. — The  board  of  directors  can  right- 
fully declare  a  dividend  only  when  sufficient  profits  exist.  It  is 
unlawful  to  pay  a  dividend  out  of  capital  and  the  directors 


184  ACCOUNTS  IN   THEORY  AND  PRACTICE 

authorizing  such  a  dividend  may  be  held  personally  for  damage 
resulting  to  creditors  of  a  corporation.  There  are,  of  course, 
various  ways  in  which  fictitious  profits  may  be  shown,  so  that 
it  is  not  always  a  simple  matter  to  determine  whether  profits 
shown  are  real  profits.  The  board  of  directors  will  protect  itself 
by  securing  the  services  of  a  competent  firm  of  public  accountants 
to  audit  the  accounts. 

As  soon  as  a  dividend  is  declared  it  becomes  the  direct  liability 
of  the  corporation.  The  routine  procedure  necessary  to  show 
this  liability  is  to  charge  Profit  and  Loss  and  credit  Dividends 
Payable,  thus: 

Profit  and  Loss 

To  Dividend  Payable  No.  — 

To  show  liability  for  dividends  declared 
in  accordance  with  vote  of  the  board 
of  directors. 

Instead  of  Profit  and  Loss  the  Surplus  account  may  be  charged. 
In  this  case,  however,  a  distinction  should  be  made  between 
capital  Surplus  arising  out  of  sale  of  stock  at  a  premium  and  Sur- 
plus derived  from  operating  profits.  It  is  wrong  to  use  capital 
surplus  to  pay  dividends.  This  distinction  has  been  recognized 
by  the  Interstate  Commerce  Commission  which  provides  a  dis- 
tinct account  for  "Premium  on  capital  stock"  which  is  shown,  not 
as  a  subdivision  of  Corporate  Surplus,  but  as  a  subdivision  of  the 
stock  account.  When  the  dividend  is  paid,  if  in  cash,  the  fol- 
lowing entry  is  made: 

Dividend  Payable  No.  — 

To  Cash 

In  payment  of  dividend  No.  — 

If  there  are  a  large  number  of  stockholders  it  is  customary  to 
draw  a  single  check  for  the  total  amount  of  the  dividend.  This  is 
placed  in  a  separate  account,  possibly  in  a  different  bank.  The 
dividend  checks  are  then  drawn  on  this  account.  This  plan 
segregates  the  work  of  paying  dividends  so  that  it  can  be  readily 
performed  by  subordinates.  If,  however,  the  dividend  is  paid 
in  stock  the  entry  is : 

Dividend  Payable  No.  — 

To  Capital  Stock 

It  should  be  noted  that  when  a  cash  dividend  is  paid  the  corpo- 
ration reduces  its  assets  by  the  amount  of  the  dividend,^  whereas 


ROUTINE  ACCOUNTING  PROCEDURE  185 

no  reduction  in  assets  occurs  when  a  stock  dividend  is  paid. 
This  is  the  principle  which  has  led  the  courts  to  declare  that  the 
receipt  of  a  stock  dividend  does  not  constitute  income  to  the 
recipient. 

Records  Peculiar  to  Corporations. — There  are  certain  books 
employed  in  corporate  finance  and  accounting  which  are  peculiar 
to  this  form  of  organization.  Some  of  these  are  required  by  state 
laws  while  the  use  of  others  is  voluntary.  The  size  of  the  cor- 
poration and  the  manner  in  which  its  stock  is  held  are  two  of 
the  factors  which  will  determine  what  special  records  are  nec- 
essary. Since  some  of  these  records  are  secretarial  in  character 
and  all  are  strictly  subordinate  to  the  accounting  records  proper, 
it  is  sufficient  here  to  give  a  brief  outline  of  their  uses.  They 
are  concerned  with  the  recording  of  minutes  of  stockholders, 
and  directors'  meetings,  the  subscriptions  for  stock  and  the  pay- 
ment thereof,  and  the  transfer  and  recording  of  capital  stock 
sold  on  the  market.     Chief  among  these  are : 

Minute  Book 
Record  of  Subscriptions 
Stock  Certificate  Book 
Register  of  Transfers 
Stock  Ledger 

The  minute  book  is  employed  to  record  the  proceedings  at 
stockholders'  and  directors'  meetings.  The  subscription  record 
contains  the  names  and  addresses  of  the  subscribers  to  the  capital 
stock,  and  the  number  and  value  of  shares  subscribed  by  each. 
The  stock  certificate  book  contains  the  stock  certificates  which  are 
issued  to  purchasers  of  stock.  Each  certificate  contains  the 
name  of  the  company,  capitalization,  total  number  of  shares 
represented  by  the  certificate,  and  whether  they  are  full  paid. 
The  register  of  transfers  records  all  transfers  of  stock  between 
buyers  and  sellers.  The  stock  ledger,  which  must  agree  with 
the  capital  stock  account,  when  the  par  value  of  holdings  is  given, 
shows  the  name  and  address  of  all  stockholders  and  the  amount 
of  stock  standing  to  the  credit  of  each. 


CHAPTER  XXIX 

THE  CORPORATION— PRACTICE 

Problem  1. — A  corporation  issues  20-year  first  mortgage  bonds 
on  January  1,  1919,  bearing  53^%  interest,  payable  semi-annu- 
ally, January  1  and  July  1.  The  trust  deed  provides  that  yearly 
contributions  are  to  be  made  to  a  sinking  fund  which  earns  3% 
compound  interest.  The  bonds  sell  at  a  premium,  as  of  January 
1,  1919.  Show  pro  forma  entries  in  journal  form  necessary  on 
the  following  dates: 

Jan.  1,  1919 

July  1,  1919 

Jan.  1,  1920 

Jan.  1,  1939 

Note. — Pro  forma  entries  are  those  with  amounts  omitted. 

Solution,  Problem  1. — 

Jan.  1,  1919 

Cash 

To  First  Mortgage  Bonds 

Premium  on  Bonds 

For  sale  of  20-year  first  mortgage  bonds,  bearing 
interest  at  6%,  due  1938,  interest  payable 
semiannually. 

July  1,  1919 

Interest  on  Bonds ■ 

To  Cash 

For  interest  on  bonds,  due  July  1,  1919. 

Premium  on  Bonds 

To  Profit  and  Loss 

One-fortieth  of  premium  on  bonds  applicable  to 
income. 

Jan.  1,  1920 

Interest  on  Bonds 

To  Cash 

For  interest  on  bonds,  due  Jan.  1,  1920. 

Jan.  1,  1920 

Premium  on  Bonds 

To  Profit  and  Loss 

One-fortieth  of  premium  on  bonds,  applicable  to 
income. 

186 


THE  CORPORATION— PRACTICE  187 

Jan.  1,  1920 


Surplus 

To  Sinking  Fund  Reserve 

Reservation  of  surplus  for  sinking  fund. 

Jan.  1,  1920 

Sinking  Fund  Trustees 

To  Cash 

Annual  payment  to  sinking  fund  trustee. 

Jan.  1,  1939 

Premium  on  Bonds 

To  Profit  and  Loss 

One-fortieth  of  premium  on  bonds  applicable  to  income. 

Jan.  ],  1939 


Surplus 

To  Sinking  Fund  Reserve 

Reservation  of  surplus  for  sinking  fund. 

Jan.  1,  1939 

Sinking  Fund  Trustees 

To  Cash 

Annual  payment  to  sinking  fund  trustee. 

Jan.  1,  1939 

Sinking  Fund  Trustees 

To  Sinking  Fund  Reserve 

For  interest  allowed  by  sinking  fund  trustee. 

Jan.  1,  1939 

First  Mortgage  Bonds 

To  Sinking  Fund  Trustees 

For  retirement  by  trustee  of  the  20-year  bM% 
first  mortgage  bonds,  due  this  date. 

Jan.  1,  1939 

Sinking  Fund  Reserve 

To  Surplus 

To  credit  surplus  with  amount  reserved  therefrom 
to  retire  bonds,  now  cancelled. 


Note. — The  problem  does  not  state  whether  the  bonds  are  to 
be  paid  from  surplus  or  from  income.  We  may  assume,  therefore, 
that  they  are  to  be  paid  from  surplus.  Interest,  however,  is 
charged  to  income.  The  proportion  of  the  premium  on  bonds 
credited  each  six  months  to  Profit  and  Loss  is  in  the  nature  of 
interest,  being  an  offset  to  the  interest  charged,  so  that  the  true 
interest  cost  is  something  less  than  5.^%.  This  might  h(ive  been 
carried  to  Profit  and  Loss  indirectly  by  first  being  credited  a 


188  ACCOUNTS  IN  THEORY  AND  PRACTICE 

nominal  account,  as,  Amortization  of  Premium  on  Debt, 
which  is  in  turn  closed  into  Profit  and  Loss  by  a  closing  journal 
entry. 

Problem  2. — A  corporation  issues  10-year  second  mortgage 
bonds  on  March  1,  1918,  bearing  interest  at  5%,  payable  semi- 
annually, March  1  and  Sept.  1.  The  trust  deed  provides  that 
annual  contributions  are  to  be  made  to  the  Acme  Trust  Co., 
sinking  fund  trustees,  to  establish  a  sinking  fund  for  the  ex- 
tinguishment of  the  bonds  when  they  fall  due.  This  sinking 
fund  earns  2%,  compound  interest.  The  bonds  sell  at  a  discount. 
Show  pro  forma  entries  in  journal  form  necessary  on  the  following 
dates: 

March  1,  1918 

Sept.  1,  1918 

March  1,  1919 

March  1,  1928 

Note. — This  problem  differs  from  the  preceding  chiefly  in  the 
fact  that  the  bonds  were  issued  at  a  discount. 

Problem  3. — A  company  under  its  articles  of  incorporation  is 
required  to  set  aside  a  certain  percentage  of  its  profits  at  the 
close  of  each  year  to  provide  a  sinking  fund  for  retiring  its  bonded 
indebtedness  when  it  matures. 

(a)  Give  necessary  entries  to  be  made  in  the  books  setting  up  the  reserve 
at  the  close  of  each  year. 

(jb)  Give  entries  required  when  the  bonds  are  paid  off  at  maturity. 
{c.   What  relation  has  the  sinking  fund  provision  to  depreciation? 

BIBLIOGRAPHY 
Part  IV.     Corporation  Accounting 

Bennett,  R.  J.     Corporation  Accounting.     New  York,  1916. 

Bentley,  H.  C.     Corporate  Finance  and  Accounting.     New  York,  1911. 

Bentley,  H.  C.     The  Science  of  Accounts.     New  York,  1911. 

Cole,  W.  M.  Accounts:  Their  Construction  and  Interpretation.  Boston, 
1915.     Appendix  B. 

Conyngton,  T.  Corporate  Organization  and  Management.  New  York, 
1917. 

Cooper,  F.     Financing  an  Enterprise.     New  York,  1915. 

Dickinson,  A.  L.  Accounting  Practice  and  Procedure.  New  York, 
1913.,     Chapter  VIII. 

EsQUERRfe,  P.  J.  Applied  Theory  of  Accounts.  New  York,  1914.  Chap- 
ters II-IV. 


THE  CORPORATION— PRACTICE  189 

Gerstenberg,   C.   W.     Materials  of   Corporation   Finance.     New   York, 

1915. 
Oilman,  S.     Principles  of  Accounting.     Chicago,  1916.     Chapter  X. 
Greendlinger,  L.     Accountancy  Problems,  Vols.  I  and  II.     New  York, 

1911. 
Keister,  D.  a.     Corporation  Accounting  and  Auditing.     Cleveland,  1905. 
Kester,    R.    B.     Accounting    Theory   and    Practice.     New    York,  1917. 

Vol.  I,  Chapters  XLVIII-XLIX.     See  also  Vol.  II,  1918. 
Klein,  J.  J.     Elements  of  Accounting.     New  York,  1913.     Chapter  VI. 
LoTJGH,  W.  H.     Business  Finance.     New  York,  1917. 
Lyons,  H,     Corporation  Finance.     Boston,  1916. 
Meade,  E.  S.     Trust  Finance.     New  York,  1903. 
Meade,  E.  S.     Corporation  Finance.     New  York,  1915. 
Paton,  W.  a.  and  Stevenson,  R.   A.     Principles  of  Accounting.     New 

York,  1918.     Chapters  XII-XIV. 
Sullivan,  J.  J.     American  Corporations.     New  York,  1910. 
Wood,  W.  A.     Modern  Business  Corporations.     Indianapolis,  1906. 


PART  V 
FINANCIAL  STATEMENTS 

CHAPTER  XXX 

CONSTRUCTION  AND  INTERPRETATION  OF  THE 
INCOME  STATEMENT 

Use  of  Income  Statement. — On  page  42  was  presented  a 
simple  form  of  income  or  profit  and  loss  statement.  The  income 
statement  is  a  popular  form  of  presentation  of  the  facts  which 
are  given  in  more  technical  form  in  the  profit  and  loss  account. 
For  some  purposes  the  account  form  is  entirely  adequate ;  but  for 
one  unskilled  in  the  technique  of  accounts  it  is  generally  better 
to  present  the  information  in  more  legible  form.  This  is  ac- 
complished by  the  use  of  the  income  statement. 

An  examination  of  the  published  reports  of  corporations  will 
indicate  how  widely  the  statement  form  has  been  adopted.  Such 
an  examination  will  also  show  to  what  extent  these  reports 
furnish  adequate  information,  and  how  much  they  fall  short  of 
completeness.  Some  companies  publish  income  statements  that 
are  wholly  inadequate  for  any  purpose  except  that  which  can  be 
satisfied  by  the  most  superficial  examination.  Much  that  is 
essential  is  purposely  omitted,  either  from  fear  of  disclosing  to 
competitors  information  which  might  be  of  aid  to  them,  or 
because  unfavorable  conditions  would  be  shown,  or  for  some  other 
reason.  The  degree  to  which  such  procedure  is  justifiable  is  a 
question  which  must  be  decided  on  the  merits  of  each  case. 

Contents  and  Arrangement  of  Income  Account. — The  contents 
of  the  profit  and  loss  account  depend  upon  the  character  of  the 
business  in  question  and  the  subdivision  of  the  nominal  accounts 
in  the  General  Ledger.  A  manufacturer  will  be  obliged  to  keep 
some  accounts  for  which  there  can  be  no  occasion  in  case  of  a 
concern  engaged  in  merchandising.     The  accounts  of  a  trans- 

191 


192  ACCOUNTS  IN  THEORY  AND  PRACTICE 

portation  company  differ  from  both  of  the  above.  It  is  custom- 
ary to  separate  the  general  profit  and  loss  account  into  sections, 
into  each  of  which  are  brought  those  items  which  affect,  or  are 
incidental  to,  a  particular  branch  of  the  work.  Thus  for  a  manu- 
facturing concern  the  general  profit  and  loss  account  permits  of  a 
subdivision  into  not  loss  than  four  sections,  possibly  more. 
These  may  be  termed : 

1.  Manufacturing  Section 

2.  Trading  Section 

3.  Administrative  Section 

4.  Distribution  Section 

If  instead  of  making  such  a  sectional  subdivision  of  the  profit 
and  loss  account,  all  items  are  entered  in  one  account,  some 
obscurity  results.  Below  is  given  such  a  profit  and  loss  account 
for  the  Acme  Manufacturing  Company,  for  the  month  ending 
June  30,  1916: 

Profit  and  Loss  Account,  Acme  Manufacturing  Co.,  Month  Ending  June  30, 

1916: 

Raw  Materials,  May  30. . .   $20,000         Raw  Materials,  June  30. . .  .$21,000 

Goods  in  Process,  May  30. .  5,000         Goods  in  Process,  June  30. .     4,000 

Finished  Goods 10,000         Finished  Goods,  June  30. .  .     9,000 

Labor 4,000        Sales 20,000 

Fuel 1,000         Discount  on  Purchases 500 

Freight  In 200         Rent  of  Steam  Power 700 

Depreciation  (factory) 100 

Taxes  (factory) 40 

Purchases  (raw  materials)...  9,000 

Advertising 320 

Salesmen's  Salaries 1,000 

Discount  on  Sales 200 

Salaries  of  Officers 600 

General  Expense 630 

Interest 427 

Bad  Debts -20 

Rent 100 

Balance,  net  Profit 2,563 


$55,200  *55,200 

The  chief  criticism  to  be  passed  upon  this  form  of  the  profit 
and  loss  account  is  its  failure  to  disclose,  at  a  glance,  the  essential 
facts  relative  to  the  manufacturing  and  trading  operations  of  the 


THE  INCOME  STATEMENT 


193 


company.  It  is  desirable  to  know  not  merely  the  net  profit 
earned  during  the  month,  but  it  is  also  desirable  to  know  the 
cost  of  manufacture,  also  of  selling.  Consider  the  following 
arrangement : 


Profit  and  Loss  Account,  Acme  Manufacturing  Co.,  Month  Ending  June  30, 

1916: 

Manufacturing  Section 

Raw  Materials,  May  31 $20,000 

Goods  in  Process,  May  31..  5,000 
Finished  Goods,  May  31 .  .  10,000 
Purchases  (raw  materials)...     9,000 

Labor 4,000 

Fuel 1,000 

Freight  In 200 

Depreciation  (factory) 100 

Taxes  (factory) 40 

$49,340 


Raw  Materials,  June  30. . . 

.  $21,000 

Goods  in  Process,  May  31. 

4,000 

Finished  Goods,  May  31. . 

9,000 

Discount  on  Purchases 

500 

Rent  of  Steam  Power 

700 

Balance  carried  to  Trading 

Section,  Cost  to  Manuf  ac 

- 

ture 

14,140 

$49,340 

Trading  Section 

Balance,  Cost  to  Manufac- 
facture $14,140        Sales. $20,000 

Advertising 320 

Salesmen's  Salaries 1,000 

Discount  on  Sales 200 

Balance  carried  to  Adminis- 
trative Section — Trading 

Profit 4,340  

$20,000  $20,000 

Administrative  Section 

Salaries  of  Officers $    600         Balance,  Trading  Profit. ..  .   $4,340 

General  Expense 630 

Interest 427 

Bad  debts 20 

Rent  (offices) 100 

Balance  carried  to  Distribu- 
tion Section— Net  Profit.     2,563  

$47340  ""  $4,340 


Distribution  Section 
Reserve  for  Contingencies...  $    500         Balance,  Net  P*rofit. 

Reserve  for  Extensions 1,000 

Balance  to  Surplus 1,063 

$2,563 


$2,563 


$2,563 


13 


194  ACCOUNTS  IN   THEORY  AND  PRACTICE 

Variations  in  Usage. — In  both  terminology  and  arrangement 
of  the  profit  and  loss  account,  there  is  much  variation  in  usage, 
among  accountants.  The  arrangement  presented  above  is  meant 
to  be  suggestive  rather  than  final.  The  fourfold  arrangement 
into  sections  is  merely  a  matter  of  utility  and  convenience. 
Sometimes  the  administrative  and  distribution  sections  are 
united.  Sometimes  they  are  entitled  differently  than  they  are 
here.  There  is  good  ground  for  assuming  that  a  particular 
item  may  with  propriety  appear  in  a  certain  section  of  the 
profit  and  loss  account  under  certain  conditions  and  in  an- 
other section  under  different  conditions,  even  in  case  of  the  same 
enterprise. 

Discount  on  Purchases. — For  example,  whether  discount  on 
purchases  ought  to  appear  in  the  manufacturing  section,  as  a 
reduction  of  cost  of  goods  purchased,  or  whether  it  ought  to 
appear  in  the  administrative  section,  as  a  profit  resulting  from 
good  management,  is  an  undecided  question.  Those  who  assert 
that  the  latter  is  the  proper  usage  do  so  on  the  ground  that  the 
ability  to  observe  cash  discount  privileges  is  due  to  (a)  pos- 
session of  sufficient  cash  to  make  the  policy  a  feasible  one,  or 
else  to  (6)  the  ability  to  make  loans  at  a  bank  in  amount 
sufficient  to  permit  such  a  policy.  It  is  maintained  that  in 
either  case  the  manufacturing  department  has  nothing  what- 
ever to  do  with  the  securing  of  the  discount,  and  that  it  is 
rightly  shown  in  the  administrative  section  as  a  premium  for 
good  management. 

The  advocates  of  the  contrary  policy,  that  is,  of  showing  the 
discount  on  purchases  in  the  manufacturing  section,  maintain 
that  the  financial  success  of  a  concern  is  dependent  as  much  if 
not  more  upon  the  efficiency  attendant  upon  the  manufacturing 
process  as  upon  any  other  function  and  that  the  presence  of 
sufficient  cash  to  enable  the  observance  of  discounts  is  therefore 
a  credit  to  the  manufacturing  department.  The  question  ap- 
pears to  be  one  that  might  permit  of  an  answer  conditioned 
upon  the  peculiarities  of  the  concern  under  consideration.  What 
made  possible  the  taking  of  the  cash  discounts?  Efficient  manu- 
facturing, efficient  trading,  or  efficient  administration?  May  it 
not  have  been  a  combination  of  the  three?  It  appears  that  the 
question  is  largely  a  theoretical  one,  which  in  practice  must  be 
decided  more  or  less  arbitrarily.  To  attempt  to  split  up  the 
amount  of  the  discounts  on  purchases  among  the  three  sections 


THE  INCOME  STATEMENT  195 

on  the  basis  of  their  relative  efficiency  would  prove  a  difficult 
task. 

Perhaps  the  best  solution  of  the  difficulty  would  be  the  aboli- 
tion of  all  cash  discounts.  There  is  really  very  little  justification 
for  them.  They  are  the  outgrowth  of  the  delinquent  methods 
fostered  by  the  antequated  system  of  open  accounts.  Their 
introduction  did  not  represent  a  step  in  advance  but  merely  a 
makeshift  remedy  for  a  system  which  has  proven  unsatisfactory. 
There  can  be  little  doubt  that  it  would  be  an  improvement  to 
make  sales  net  10  days,  or  net  30  days,  or  for  whatever  time  the 
nature  of  the  trade  makes  desirable.  It  is  to  be  hoped  that 
the  adoption  of  the  trade  acceptance  will  remedy  the  situation, 
although  it  is  by  no  means  necessary  to  abolish  cash  discounts  in 
order  to  make  use  of  the  trade  acceptance.  But  by  making 
prompt  payment  of  bills  a  habit  it  may  remove  the  necessity  for 
cash  discounts.  Cash  discounts  have  given  rise  to  a  variety 
of  abuses  that  may  thus  be  ended. 

Arrangement  of  the  Profit  and  Loss  Statement. — With  these 
remarks  about  the  possibility  of  disagreement  upon  the  location 
to  be  ascribed  to  individual  items  in  the  profit  and  loss  account, 
let  us  now  consider  the  rearrangement  of  the  items  of  the  profit 
and  loss  account  required  to  form  the  profit  and  loss  statement. 
The  purpose  of  the  profit  and  loss  statement  is  to  present  in  non- 
technical form  the  information  contained  in  the  profit  and  loss 
account.  A  little  reflection  will  show  that  the  amount  of  sales 
in  a  profitable  enterprise  will  be  sufficient  to  cover  all  costs  of 
manufacture,  trading,  and  administration,  and  leave  a  balance 
representing  net  profits.  Omitting  details,  this  may  be  expressed 
as  a  yro  forma  statement,  thus : 


Sales 

Deduct :  Cost  to  Manufacture . . 

Cost  of  Selling 

Cost  of  Administration . 
Net  Profit 


This  is  all  right  as  far  as  it  goes,  but  it  hides  too  much  desirable 
information.  It  requires  expanding  and  amplifying.  Consider 
the  following,  which  is  merely  a  rearrangement  of  the  items  shown 
in  the  profit  and  loss  account  presented  on  page  193,  with  the 
costs  of  manufacture  expressed  as  one  item : 


196  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Profit  and  Loss  Statement,  The  Acme  Manufacturing  Co.,  Month  Ending 

June  30,  1916 : 

Sales $20,000     100% 

Less  Cost  of  Goods  Sold 14,140 

Gross  Profit  on  Sales $  5,860—% 

Selling  Expenses:  . 

Advertising $    320 

Salesmen's  Salaries 1,000 

Discount  on  Sales 200    $1,520 

Administrative  Expenses: 

Salaries  of  Officers $600 

General  Expense 630 

Interest 427 

Bad  Debts 20 

Rent  (offices) 100    $1,777  3,297  — % 

Net  Profit 2,563  — % 

Distribution  of  Net  Profit: 

Reserve  for  Contingencies $    500 

Reserve  for  Extensions 1,000  1,500 

Surplus $],063  — % 

If  it  is  desirable  to  show  the  costs  of  manufacture  in  detail, 
this  may  be  done  by  substituting  for  the  single  item,  "Cost  of 
Goods  Sold,"  the  detailed  costs  of  manufacture,  in  the  above 
statement,  which  then  becomes: 

Profit  and  Loss  Statement,  The  Acme  Manufacturing  Co.,  Month  Ending 

June  30,  1916 : 

Sales $20,000     100% 

Less  Cost  of  Goods  Sold : 

Raw  Materials,  May  31 $20,000 

Goods  in  Process,  May  31 5,000 

Finished  Goods,  May  31 10,000     $35,000 

Raw  Materials,  June  30 $21,000 

Goods  in  Process,  June  30 ...  .         4,000 
Finished  Goods,  June  30 9,000       34,000 

$  1,000 

Purchases  (raw  materials) 9,000 

Labor 4,000 

Fuel 1,000 

Freight  in 200 

Depreciation  (factory) 100 

Taxes  (factory) 40 

$15,340 


THE  INCOME  STATEMENT  197 

Less: 

Discount  on  Purchases %  500 

Rent  of  Steam  Power 700       $1,200     $14,140         — % 

Gross  Profit  on  Sales $5,860      24.3% 

Selling  Expenses: 

Advertising $320 

Salesmen's  Salaries 1,000 

Discount  on  Sales 200      $1,520 

Administrative  Expenses : 

Salaries  of  Officers $600 

General  Expense 630 

Interest 427 

Bad  debts 20 

Rent  (offices) 100       $1,777       $3,297  ' 

Net  Profit $2,563      12.3% 

Distribution  of  Net  Profit: 

Reserve  for  Contingencies $500 

Reserve  for  Extensions 1,000       $1,500 

Surplus $1,063         — % 

The  possibilities  of  variation  from  the  above  form  are  very 
great.  It  merely  illustrates  a  type  of  statement  that  is  widely 
used.  Such  statements  differ  much  in  both  terminology  and 
construction.  It  is  improbable  that  complete  standardization 
of  the,  form  of  the  income  account  will  be  adopted,  even  we  e  it 
desirable.  The  peculiarities  of  different  kinds  of  enterprises 
require  variations  in  the  forms  of  such  statements.  However, 
it  is  undeniable  that  standardization  in  a  given  line  of  business 
is  desirable;  for  only  through  standardization  is  it  possible  to 
arrive  at  comparisons  between  concerns  upon  an  exact  and  in- 
telligible basis. 

Net  Sales  an  Important  Statistical  Base. — In  the  above  state- 
ment no  "returned  sales  and  allowances"  are  indicated.  When 
there  is  such  an  item  it  must  be  deducted  from  sales  to  arrive  at 
net  sales.  The  figure  for  net  sales  is  very  important  because  it 
is  the  best  basis  from  which  to  figure  the  percentage  of  the  various 
items  of  cost,  expense,  etc.  If  net  sales  is  taken  as  100  per  cent, 
then  all  following  items  in  the  income  statement  can  be  figured 
as  a  percentage  on  net  sales.  This  suggests  great  possibilities 
in  the  way  of  comparison  and  interpretation.  In  the  above 
statement  the  gross  profit  on  sales  is  $5,860,  or  24.3  per  cent  of 


198  ACCOUNTS  IN   THEORY  AND  PRACTICE 

net  sales.  The  net  profit  is  12.315  per  cent  of  net  sales.  Simi- 
larly any  or  all  other  items  may  be  expressed  as  a  percentage  of 
net  sales.  For  comparisons,  either  between  different  accounting 
periods  in  the  history  of  the  same  concern,  or  between  contempo- 
raneous periods  in  the  history  of  different  concerns,  the  expression 
of  all  significant  items  in  the  income  statement  as  percentages 
on  net  sales  at  once  reduces  all  to  one  basis.  Relationship  thus 
expressed  is  much  more  intelligible  than  when  the  items  compared 
are  expressed  absolutely  in  dollars  and  cents. 

Significance  of  Income  Statement — Deductions  from  Assets. — 
The  full  significance  and  bearing  of  the  income  statement  can  be 
comprehended  only  by  studying  its  significant  component  parts 
in  their  relation  to  one  another  and  in  their  bearing  upon  the 
assets  and  liabilities  as  presented  in  the  balance  sheet.  Thus 
there  are  certain  items  of  expense  found  in  the  income  statement 
which  represent  deductions  from  asset  values,  sloughings-off,  so 
to  say,  in  the  form  depreciation  and  bad  debts.  The  amount  of 
the  taxes  depends  upon  the  valuation  of  the  assets.  Fuel 
expense  represents  the  consumption  of  an  asset.  The  income 
statement  measures  changes  in  assets  and  liabiUties  during  the 
period  covered. 

The  Inventories. — Again,  the  income  statement  renders  it 
possible,  at  least  to  a  degree,  to  determine  the  normahty  or 
abnormality  of  assets  and  liabilities  when  considered  in  their 
relative  positions.  Thus  the  relative  size,  and  the  increases  and 
decreases  in  the  inventories  are  shown  with  special  clearness 
when  they  are  expressed  as  percentages  of  net  sales.  A  consid- 
erable increase  in  the  inventories  may  be  legitimate;  on  the  other 
hand  it  may  indicate  overbuying,  and  possibly  stagnation.  Any 
unnecessary  increase  in  the  inventories  requires  the  useless  tying 
up  of  working  capital.  It  also  means  added  interest  cost.  Simi- 
larly, the  various  manufacturing  costs,  labor,  fuel,  and  so  on, 
may  be  expressed  both  in  dollars  and  as  percentages,  and  their 
tendencies  shown.  Changes  in  selUng  expenses  may  be  noted 
and  studied. 

The  Fixed  Charges. — Among  most  important  classes  of 
items  shown  in  the  income  statement  are  the  fixed  charges. 
These  do  not  fluctuate  (or  if  so,  but  little)  with  fluctuations  in 
the  amount  of  business  transacted.  Among  them  are  included 
taxes,  rents,  interest,  and  so  on.  They  represent  the  low  water 
mark  beneath  which  the  income  of  the  business  should  not  be 


THE  INCOME  STATEMENT  199 

permitted  to  fall.  When  income  is  insufficient  to  cover  all 
ordinary  expenses,  operating  and  fixed,  it  may  be  possible  to 
curtail  on  the  operating  expenses,  such  as  labor,  fuel,  and  adver- 
tising, and  possibly,  too,  on  some  of  the  administrative  expenses, 
such  as  salaries,  but  up  to  a  certain  point  only,  while  it  is  unlikely 
that  the  fixed  charges  can  be  reduced  at  all.  They  must  be  met. 
Hence  the  necessity  of  keeping  them  within  reasonable  limits. 

Margin  of  Profits. — The  margin  of  profits  remaining  after 
all  fixed  charges  have  been  accounted  for  is  one  of  the  most  im- 
portant indices  of  the  financial  condition  of  an  enterprise.  If 
this  margin  is  a  narrow  one  the  enterprise  stands  in  jeopardy 
of  having  all  of  its  income  consumed  by  its  expenses,  and  of  being 
unable  to  meet  its  fixed  charges,  or  else  of  being  able  to  meet 
them  only  by  curtailing  some  of  its  usual  expenses  of  operation 
and  administration.  The  possibility  of  a  concern's  failing  to 
meet  its  fixed  charges  is  dependent  not  only  upon  the  amount  of 
those  charges  but  also  upon  the  fluctuations  of  its  gross  income 
from  sales  or  services.  If  gross  income  continues  quite  uniform 
from  year  to  year  the  concern's  ability  to  assume  and  meet 
fixed  charges  can  be  accurately  gauged.  But  if  its  gross  income 
fluctuates  greatly  from  year  to  year,  its  ability  to  carry  a  burden 
of  fixed  charges  is  correspondingly  reduced.  The  poorer  years 
become  the  measure  of  what  an  enterprise  can  hope  to  do  in  the 
way  of  carrying  fixed  charges. 

Steadiness  of  Income. — Steadiness  and  uniformity  of  income 
vary  somewhat  between  enterprises  engaged  in  the  same  line  of 
business — due  to  location,  management,  and  so  on.  In  different 
lines  of  business  there  exists  great  disparity  in  this  respect. 
In  some  cases  income  remains  steady  month  after  month  and 
year  after  year.  In  other  cases  it  is  seasonal,  but  nevertheless 
one  year  returns  a  total  income  about  equal  to  that  of  other  years. 
In  still  other  lines  of  business  there  exist  great  variations  in 
income  from  year  to  year,  depending  in  large  measure,  perhaps, 
on  events  the  future  occurrence  of  which  remains  in  uncertainty. 

An  example  of  steady  uniform  income  is  furnished  by  many 
public  utihty  companies.  A  street  car  company  is  quite  certain 
of  enjoying  a  steady  and  uninterrupted  demand  for  transporta- 
tion. The  same  is  true  of  gas,  water,  and  electric  companies. 
As  a  consequence,  such  companies  can  safely  operate  on  a 
narrower  margin  of  profits  than  can  concerns  engaged  in  more 
hazardous  undertakings.     The  opposite  extreme  is  illustrated  by 


200  ACCOUNTS  IN   THEORY  AND  PRACTICE 

the  so-called  industrials  and  mining  companies.  Here  market 
fluctuations,  both  in  prices  of  raw  materials  and  finished  pro- 
ducts, are  great.  General  business  conditions  are  very  influential 
factors.  Various  factors  conspire  to  make  the  incomes  of  even 
the  greatest  of  such  enterprises  changeable  and  uncertain. 
Steamship  companies  also  fall  into  this  class.  Rates  for  ocean 
transportation  fluctuate  greatly  from  season  to  season  and  from 
year  to  year.  Rate  agreements  are  difficult  to  secure  and  still 
more  difficult  to  maintain.  A  poor  harvest  on  one  continent 
lies  entirely  beyond  the  control  of  a  trans- Atlantic  ship  company, 
yet  it  may  very  materially  affect  its  earnings. 

Need  of  Reserving  Profits. — Such  being  the  conditions,  each 
kind  of  business  must  recognize  that  there  are  certain  maxima 
and  minima  which  experience  has  shown  are  likely  to  occur  in 
the  income  of  an  enterprise  engaged  in  that  business.  These 
must  be  considered  in  determining  what  amount  may  safely  be 
depended  upon  for  meeting  fixed  charges,  year  after  year. 
Moreover,  to  add  a  further  protection,  a  concern  ought  to  reserve 
a  certain  amount  of  its  profits  as  surplus,  and  this  surplus  should 
be  large  in  proportion  to  the  uncertainty  of  the  income.  If  this 
policy  is  consistently  pursued,  an  enterprise  engaged  in  an  under- 
taking the  income  of  which  is  subject  to  considerable  changes 
may  place  itself  in  a  position  of  comparative  safety,  compensat- 
ing for  occasional  reductions  in  income  by  encroachments  upon 
the  surplus  account.  Such  a  policy  cannot  be  pursued,  of  course, 
unless  in  prosperous  years  there  is  earned  enough,  over  and  above 
ordinary  requirements,  to  establish  the  surplus.  When  it  can 
be  done,  immunity  from  those  disturbances  that  so  adversely 
affect  poor  concerns  of  a  like  character  is  secured,  and  correspond- 
dingly  larger  fixed  charges  can  be  assumed. 

Relation  of  Question  to  Borrowing. — This  theoretical  discus- 
sion receives  practical  application  in  the  establishment  of  a 
bonded  indebtedness.  What  proportion  of  its  capital  a  corpora- 
tion ought  to  secure  by  the  sale  of  capital  stock  and  what  by  the 
sale  of  bonds  depend  upon  various  considerations,  some  of  which 
are  likely  to  be  peculiar  to  the  individual  company.  However, 
some  general  principles  apply.  Certainly  a  concern  ought  not 
to  attempt  to  secure  all  of  its  capital  by  means  of  bond  issues, 
for  in  such  a  case  all  invested  capital  would  require  the  im- 
position of  a  fixed  charge  in  the  form  of  interest.  This  would 
permit  no  leeway  whatever,   no  room  for  the  expansion  and 


THE  INCOME  STATEMENT  201 

contraction  that  accompany  all  kinds  of  undertakings.  Some 
corporations  have  no  bonded  indebtedness,  and  so  corporations 
may  be  graded  into  classes  which  run  all  the  way  from  those 
without  any  permanent  indebtedness  to  those  in  which  the 
funded  indebtedness  exceeds  the  outstanding  capital  stock. 

No  ideal  proportion  for  stocks  and  bonds  exists.  Even  though 
one  might  be  established  theoretically  it  is  not  likely  that  it  could 
be  adhered  to  in  practice.  The  proportion  of  stocks  to  bonds  is 
not  determined  by  any  single  consideration,  but  by  a  variety  of 
factors,  sometimes  conflicting  in  character.  It  might  not  be 
desirable  to  increase  the  bonded  indebtedness  because  fixed 
charges  are  already  as  large  as  the  fluctuating  income  will  safely 
carry.  Yet  they  may  be  the  only  recourse.  It  may  be  impos- 
sible to  market  stocks  satisfactorily.  Statutory  requirements 
must  be  observed. 

The  student  should  distinguish  between  the  monthly  income 
statement,  which  is  made  up  as  quickly  as  possible  after  the 
close  of  each  month,  and  the  yearly  income  statement,  which  is 
intended  for  publication  or  at  any  rate  for  a  permanent  source  of 
statistical  data.  The  monthly  income  statement  is  necessarily 
inexact  in  certain  respects  owing  to  the  fact  that  there  are  ex- 
penses, losses  and  gains  which  cannot  be  determined  definitely 
until  a  considerable  time  after  they  occur.  Certain  readjust- 
ments may  be  necessary.  Overlappings  occur  from  month  to 
month  which  it  is  difficult  to  allocate  with  exactness  on  a  monthly 
basis.  Among  items  of  this  sort  may  be  mentioned  the  expenses 
incurred  by  traveling  representatives,  doubtful  accounts  re- 
ceivable, and  so  on. 

For  this  reason  the  yearly  income  statement  serves  better  as  a 
permanent  record  of  achievement  than  does  a  statement  covering 
a  shorter  period.  Varying  seasonal  influences  which  create 
wide  differences  in  monthly  statements  are  eliminated  in  annual 
statements,  so  that  the  only  disturbing  external  factors  are  those 
of  an  irregular  character  to  which  all  enterprises  are  more  or  less 
subject,  such  as  depressions,  interest  rates,  changes  in  labor  costs, 
and  the  like. 


CHAPTER  XXXI 
THE  INCOME  STATEMENT  ILLUSTRATED 

Illustrative  Statements. — As  has  been  suggested,  the  form  and 
contents  of  the  income  statement  depend  upon  the  character  of 
the  enterprise.  Illustrative  of  this  fact  we  shall  reproduce  two 
typical  income  accounts  taken  from  the  annual  reports  of  the 
Delaware,  Lackawanna  &  Western  Railroad  Company  and  the 
United  States  Steel  Corporation,  respectively.  Below  is  the 
income  statement  of  the  Delaware,  Lackawanna  &  Western 
Railroad  Company  for  the  year  ending  December  31,  1916. 

Comment  on  Above  Illustration. — This  is  the  form  of  income 
account  prescribed  by  the  Interstate  Commerce  Commission. 
It  became  effective  July  1,  1914.  Defects  in  the  earlier  forms 
had  become  apparent  through  the  investigations  of  certain 
railroad  companies.  By  way  of  suggesting  methods  of  inter- 
pretation Hooper,  in  his  book  on  Railroad  Accounting,  says: 
"Even  a  superficial  study  of  the  comparative  income  account 
would  include  a  comparison  of  the  increase  or  decrease  in  rail- 
way operating  revenues  with  a  normal  increase  or  decrease  and 
with  the  increase  or  decrease  shown  by  other  railroad  companies 
in  the  same  territory,  the  trend  of  the  ratio  of  operating  expenses 
to  operating  revenues,  the  trend  of  taxes  and  its  ratio  to  operating 
revenues,  the  trend  or  changes  in  hire  of  freight  cars  and  rent  of 
of  other  equipment,  the  trend  of  profit  or  loss  from  separately 
operated  properties,  the  changes  in  interest  on  funded  debt 
and  on  unfunded  debt,  dividend  appropriations  and  appropria- 
tions for  investment  from  income,  and  of  course,  the  balance 
transferable  to  profit  and  loss."^ 

If  the  income  statement  affords  insufficient  information  on 
any  point  aid  may  be  secured  by  using  the  balance  sheet  and  the 
various  supplementary  statements  which  ordinarily  accompany 
the  income  statement.  Hooper  says  further:  "  Any  considerable 
change  in  the  balance  for  hire  of  freight  cars  or  other  equipment 
should  be  compared  with  the  amount  of  business  done  and  with 
the  charges  made  to  expenses  for  retirements  of  equipment  and 
also  with  capital  charges  for  new  equipment  as  shown  on  the 
balance  sheet."     It  is  noteworthy  that  whereas,  in  1915,  the 

*  Hooper,  Wm.  E.,  Railroad  Accounting,  p.  223. 

202 


THE  INCOME  STATEMENT  ILLUSTRATED 


203 


Annual  Report  of  The  Delaware,  Lackawanna  &  Western  Railroad  Company 
for  the  Year  Ending  December  31,  1916  : 


1916                          1915                  Per  cent 

Revenues: 
From  Transportation  of  Coal 

$14,475,244.09 

23,229,864.82 
8,674,863.13 
235,728.89 
1,068,662.21 
1,086,733.73 
1,808.878.97 
1.000.923.23 

$13,364,006.89 

18,742,617.06 

8,218,316.43 

211,766.24 

873,317.56 

1.084.979.60 

Inc.      8.32 

From    Transportation    of    Merchandise 

Freight 

From  Transportation  of  Passengers 

From  Transportation  of  Mail 

Inc.    23.94 
Inc.       5.56 
Inc.     11.32 

From  Transportation  of  Express 

Inc.    22.37 
Inc.          .16 

Other  Revenue  from  Transportation 

Incidental  Revenue 

1,567.783.33  line.     15.38 
723,943.77    Inc.    38.26 

Total  Revenues 

$51,580,899.07 

$44,786,730.88  ilnc.     15.17 

Expenses: 
For  Maintenance  of  Way  and  Structures. 
For  Maintenance  of  Equipment 

$  4,819.787.28 

$  7,616,683.81 

915,300.54 

$  4.662,311.01 

$  6,869,899.60 

Q20..'i5fi  07 

Inc.       3.38 
Inc.     10.87 
Dec.        .  57 

For  Transportation  Expenses  

17.167,742.83  j     14,222,296.73 
406,418.51              350.504.82 

Inc.    20.71 

For  Miscellaneous  Operations 

Inc.     15.95 

For  General  Expenses 

1,054,746.23 
39,705.18* 

951.999.79 
210.621.30* 

Inc.     11.97 

For  Transportation  for  Investment-Cr... 

Dec.  81.15 

Total  Expenses 61.92% 

$31,940,974.02 

$27,756,946.72 

Inc.     16.07 

tion 38.08%. 

$19,639,925.05 

$17,029,784.16 

Inc.     15.33 

Less  Railway  Tax  Accruals 

Less  Uncollectible  Railway  Revenues.  - .  . 

$  2.517.882.68 
7,449.64 

$  2,115,333.84 
1,505.40 

Inc.     19.03 
Inc.  394.86 

Operating  Income 

$17,114,592.73 

$14,912,944.92 

Inc.     14.76 

Add  for  Additional  Income: 

Joint  Facility  Rent  Income 

Miscellaneous  Rent  Income 

$        81.059.91 
235.664.85 
476,936.50 
237,547.58 

516,071.71 
2,899,309.37 
2,033,713.19 
1,052,261.97 

$        74.203.99 
242.326.17 
405.501.06 
271.725.34 

367.244.69 
1,536,916.36 
1,906,123.16 

199,532.80 

Dividend  Income 

Income  from   Unfunded  Securities  and 

Accounts 

Coal  Department  Earnings 

Depletion  of  Coal  Deposits 

Sundry  Additions  and  Deductions 

$  7,532,565.08 

5,003,573.57 

Total  Income 

$24,647,157.61 

$19,916,518.49 

Deductions  From  Income: 

Hire  of  Equipment-Debit  Balance 

Rent  for  Leased  Roads 

$      755,733.83 

5,983,152.26 

1,701,967.66 

6,156.00 

$         22.439.94* 

6,063,815.49 

1,616,056.13 

6,247.00 

1,289,700.00 

Renewals  and  Betterments 

Interest  on  Funded  Debt 

Discount  on  Bonds  Sold 

Total  Charges 

$  8,447.009.75 

$8,953,378.68 

Lcm: 
Ten  Per  Cent.  (10% )  Dividends  on  Stock. 
Ten   Per  Cent.   (10%)   Extra   Dividend 

Payable  December  20,  1016 

$16,200,148.06 
$  4,222,040.00 
$  4,222,040.00 

$10,063,139.81 
$  4,222,040.00 
$  4,222,040.00 

$  8.444.080.00 
$  7.756.068.06 

$  8,444,080.00 
$  2.519.059.81 

Balance,  Surplus 

*  Credit  itema. 


204  ACCOUNTS  IN  THEORY  AND  PRACTICE 

* 
Delaware,  Lackawanna  &  Western  had  a  credit  balance  of  $22,- 
439.94  in  its  "Hire  of  Equipment"  account,  in  1916  this  changed 
to  a  debit  balance  of  $755,733.83.  This  increased  use  of  rented 
equipment  is  fully  explained  by  the  extraordinary  increase  of 
traffic  in  1916.  The  coal  traffic  of  this  company  increased  16 
per  cent,  in  tonnage  while  its  merchandise  traffic  increased  26.15 
per  cent.,  as  fully  set  forth  in  the  company's  annual  report. 

Under  the  head  of  "deductions  from  income"  we  note  that  in 
1915  there  was  charged  $1,289,700.00  for  "discount  on  bonds 
sold."  In  the  company's  report  for  1915  it  is  explained  that  this 
sum  was  charged  against  income  to  cover  the  discount  on  the  3}^ 
per  cent  bond  issue  of  a  subsidiary,  the  Morris  &  Essex  Railroad 
Company,  the  proceeds  from  which  were  employed  to  pay  off 
certain  outstanding  bonds  of  that  subsidiary.  The  reason  the 
company  chose  to  charge  off  the  entire  amount  of  the  discount  on 
its  bonds  in  a  single  year  is  explained  below. 

The  classification  of  revenue  and  of  operating  expenses  re- 
quired by  the  Interstate  Commerce  Commission  should  be  noted. 
The  account,  "Transportation  for  Investment — Cr.,"  requires 
explanation.  A  railroad  company  is  constantly  engaged  in 
transporting  workmen  and  materials  from  point  to  point  along 
its  lines  for  the  purpose  of  making  improvements  or  engaging  in 
new  construction  work.  The  cost  of  such  transportation  is  not 
an  expense,  but  an  investment.  Since,  however,  it  cannot  be 
separated  from  the  ordinary  operating  expenses  when  incurred, 
it  is  deducted  from  them  in  the  profit  and  loss  statement  and  of 
course  is  charged  in  the  company's  ledger  to  the  appropriate 
property  investment  accounts. 

The  Operating  Ratios. — Note  that  the  ratio  of  operating  ex- 
penses to  revenues  from  operation  is  61.92  per  cent.  This  ratio 
is  of  considerable  importance  as  an  aid  in  the  interpretation  of 
the  income  accounts  of  railroad  companies  as  well  as  of  other 
enterprises.  It  is  familiarly  known  as  the  operating  ratio.  It 
must  be  employed  with  reservation  and  judgment,  however. 
It  is  easy  to  see  that  as  between  enterprises  of  essentially  different 
natures  it  does  not  afiford  a  fair  basis  of  comparison ;  while  between 
enterprises  of  a  like  character  it  would  be  very  rare  indeed  to 
have  no  differences  which  might  in  some  degree  invalidate  the 
worth  of  the  comparison.  Unquestionably,  railroads  afford  one 
of  the  best  illustrations  of  an  adequate  basis  for  a  legitimate 
comparison  of  operating  ratios,  because  railroad  accounts  are 


THE  INCOME  STATEMENT  ILLUSTRATED  205 

fully  standardized.  Not  only  does  the  operating  ratio  afford  a 
basis  of  comparison  between  two  or  more  companies  over  a  given 
period,  but  it  also  affords  a  valuable  check  upon  changes  which 
occur  at  various  periods  in  the  history  of  a  given  concern.  As 
in  railroad  accounting  all  items  in  the  income  statement  are 
expressed  as  percentages  of  revenue,  so  in  the  income  statement 
of  a  trading  of  a  manufacturing  concern  all  items  are  expressed 
as  percentages  (A  net  sales. 

Other  Income,  etc. — Frequently  an  income  is  derived  from 
sources  other  than  chief  operations  of  the  enterprise.  Such  in- 
come is  known  as  "other  income."  Thus  any  revenue  that  a 
railroad  company  derives  from  activities  other  than  trans- 
portation is  other  income.  In  case  of  the  Delaware,  Lacka- 
wanna &  Western  other,  or  "additional,"  income  amounted  to 
$7,532,565.08  in  1916  and  to  somewhat  over  $5,000,000.00  in 
1915.  When  such  additional  income  is  added  to  income  from 
operations  the  sum  is  "total  income."  From  total  income  are 
deducted  various  rentals  and  fixed  charges — the  desideratum  of 
the  expenses  after  operating  expenses  are  deducted.  The  pro- 
priety of  charging  "Betterments"  as  an  expense  might  be  ques- 
tioned. Theoretically  betterments  should  be  charged  to  capital 
and  ought  not  to  appear  in  the  income  account.  "Renewals," 
on  the  other  hand,  is  a  proper  charge  to  income.  Indeed,  the 
charging  of  betterments  to  income  is  a  variation  from  the  re- 
quirements of  the  Interstate  Commerce  Commission;  it  makes 
no  provision  for  charging  betterments  to  income,  unless  we  may 
assume  that  such  a  charge  might  be  made  under  the  general 
head  of  "miscellaneous  income  charges." 

As  noted,  the  Delaware,  Lackawanna  &  Western  charged  off, 
in  a  single  year,  the  entire  discount  on  its  issue  of  3^  per  cent 
bonds.  The  usual  procedure  in  such  cases  is  to  prorate  the  dis- 
count over  the  life  of  the  bonds,  charging  off  the  proper  amount 
each  year.  Under  the  rules  of  the  Interstate  Commerce  Commis- 
sion, however,  a  railroad  company  has  the  option  of  charging  off, 
at  any  time,  any  remaining  portion  of  such  discount,  providing 
there  is  sufficient  surplus  to  permit  it.  The  latter  policy  appears 
to  have  been  adopted  by  the  Delaware,  Lackawanna  &  Western. 

A  noticeable  feature  of  the  income  statement  of  this  company 
is  the  small  interest  charge  on  the  funded  debt.  In  1916  the 
funded  debt  of  the  company  was  $320,000;  its  capital  stock  was 
$42,277,000.     The  funded  debt  amounted  to  less  than  1  per  cent 


206 


ACCOUNTS  IN  THEORY  AND  PRACTICE 


of  the  outstanding  stock — a  situation  not  often  found  in  railroad 
finance.  After  paying  two  dividends  of  10  per  cent,  each  in  1916, 
there  remained  out  of  current  income  $7,756,068.06,  to  carry 
to  surplus,  increasing  the  total  surplus  to  $46,987,405.33,  or  more 
than  the  combined  par  value  of  outstanding  stocks  and  bonds. 


1915 

1914 

-|-  Increase 
—  Decrease 

Earnings — Before  charging  interest 
on  Bonds  and  Mortgages  of  Sub- 

$15,082,369.36 
30.536,467.71 
41.050.432.47 
53.580.796.79 

$20,450,988.60 
22,956.414.32 
24,792,603.80 
13,546.511.14 

-$  5,368,619.24 

+     7,580,053.39 

Third  Quarter 

+   16,257,828.67 

+  40,034,285.65 

$140,250,066.33 
9,854,054.69 

$81,746,517.86 
10.082.902.69 

-h  $58.503,548. 47 

Less,  Interest  on  outstanding  Bonds 
and  Mortgages  of  the  Subsidiary 

-         228,848.00 

Balance  of  Earnings 

$130,396,011.64 

24,408.576.60 
1.553.587.99 
6,465,884.26 

$71,663,615.17 

17.044,183.32 
1,903,041.68 
6,195.982.41 

+$58,732,396.47 

Less,   Charges  and   Allowances  for 
Depreciation  applied  as  follows, 
vit.: 
To   Depreciation  and  Extraordi- 

+     7,364,393.28 

To  Sinking  Funds  on  Bonds  of 
Subsidiary  Companies 

To  Sinking  Funds  on  U.  S.  Steel 
Corporation  Bonds  

349,453.69 
+        269.901.85 

Net  Income  in  the  year 

Deduct: 

Interest  on  U.  S.  Steel  Corpora- 

$  97,967,962.79 

21,928,633.74 

107,210.28 
864,100.00 

$46,520,407.76 

22.239.086.53 

87.331.46 
822.200.00 

+  $51,447,555.03 
-         310.452.79 

Premium  paid  on  Bonds  redeemed 

by  Sinking  Funds,  vis.: 

On  Subsidiary  Companies'  Bonds 
On  U.  8.  Steel  Corporation 

Bonds 

+           19,878.82 
+           41,900.00 

Balance 

$  75,068,018.77 
765,813.94 

$23,371,789.77 
124.978.40 

+  $51,696,229.00 

Add :  Net  Balance  of  sundry  charges 
and  credits,  including  adjustments 

+         640,835.54 

$75,833,832.71 

25,219,677.00 
6,353,781.25 

$23,496,768.17 

25,219,677.00 
15,249,075.00 

+  $52,337,064.54 

Dividends  on  U.  S.  Steel  Corpora- 
tion Stocks,  viz.: 

Preferred.  7  % 

Common,     1915-l>i%.    1914- 
3  % 

-     8,895.293.75 

Surplus  Net  Income  for  the  year 

$44,260,374.46 

$16,971,983.83' 

+  $61,232,358.29 

Deficit. 


THE  INCOME  STATEMENT  ILLUSTRATED  207 

United  States  Steel  Corporation. — Above  is  the  comparative 
income  statement  of  the  United  States  Steel  Corporation  for 
the  years  ending  Dec,  31,  1914  and  1915,  respectively. 

Comment  on  Above  Illustration. — The  United  States  Steel 
Corporation  is  more  liberal  than  most  of  the  larger  industrial 
companies  in  the  matter  of  publicity.  Nevertheless  we  find  this 
income  statement  less  satisfactory  than  the  preceding  one. 
Gross  and  net  sales  and  operating  expenses  are  not  shown. 
Practically,  the  manufacturing  and  trading  sections  are  omitted, 
and  only  the  deductions  of  the  fixed  charges  are  shown.  Pre- 
sumably the  officials  consider  it  inadvisable  to  present  a  fuller 
statement.  The  statement  shows  the  remarkable  fluctuations 
to  which  such  enterprises  are  subjected  by  general  financial  and 
business  conditions.  In  spite  of  the  smaller  deductions  for 
depreciation  made  in  1914,  there  were  not  sufficient  profits  to 
meet  the  usual  dividend  requirements;  and  as  a  result  the  ac- 
cumulated surplus  was  diminished  by  nearly  $17,000,000.  In 
1915,  on  the  other  hand,  the  profits  were  three  times  as  great 
as  in  1914,  making  possible  a  substantial  addition  to  surplus  of 
over  $44,000,000,  although  the  common  stock  dividend  was  cut 
to  13^^  per  cent. 

These  illustrations  indicate  the  possible  differences  and  varia- 
tions in  income  statement  construction.  When  enterprises  are 
unlike,  differences  are  necessary.  When  they  are  alike,  uniformity 
is  desirable. 


CHAPTER  XXXII 

CONSTRUCTION  AND  INTERPRETATION  OF  THE 
BALANCE  SHEET 

The  balance  sheet  and  the  income  statement  are  complemen- 
tary business  documents.  They  are  the  two  most  condensed 
and  comprehensive  sources  of  information  that  have  been  con- 
trived for  the  presentation  of  facts  concerning  the  progress  and 
condition  of  an  enterprise.  The  construction  and  interpretation 
of  the  income  statement  were  discussed  in  the  preceding  chapters. 
In  this  chapter  the  balance  sheet  will  be  considered. 

Arrangement  of  the  Balance  Sheet. — A  balance  sheet  should 
afford  a  systematic  classification  of  assets  and  habihties.  It 
indicates  their  condition  at  a  given  instant,  and  shows  the  changes 
that  have  taken  place  during  the  preceding  accounting  period, 
when  a  comparison  is  made  with  the  preceding  balance  sheet. 
Since  the  purpose  of  the  balance  sheet  is  to  show  as  nearly  as 
possible  the  financial  condition  of  an  enterprise,  its  general  form 
and  arrangement  should  be  determined  upon  this  consideration. 
In  this  country  we  think  of  the  balance  sheet  as  a  statement 
hsting  assets  on  the  left  side  and  liabihties,  capital,  and  surplus 
on  the  right  side,  although  we  frequently  meet  with  variations 
from  this  form.  Perhaps  the  most  notable  is  that  in  which  the 
arrangement  corresponds  in  a  general  way  with  the  income 
statement.  Here  the  assets  are  placed  above  and  the  habilities 
and  proprietary  accounts  below.  In  England  the  general  arrange- 
ment is  reversed,  the  liabihties  and  proprietary  accounts  being 
placed  to  the  left  and  the  assets  to  the  right.  These  three  forms 
of  the  balance  sheet  are  illustrated  below: 

Balance  Sheet  of  the  A.  B.  Co. : 

Assets  LiabUities 

Plant $10,000  Capital  Stock S14,000 

Machinery 4,000  Accounts  Payable 3,000 

Merchandise 3,000  Surplus 1,000 

Cash 1,000  

$18,000  $18,000 

208 


THE  BALANCE  SHEET  209 

Balance  Sheet  of  the  A.  B.  Co. : 


Plant ■ $10,000 

Machinery 4,000 

Merchandise 3,000 

Cash 1,000 

$18,000 

Liabilities 

Capital  Stock $14,000 

Accounts  Payable 3,000 

Surplus. 1,000 

$18,000 

Balance  Sheet  of  the  A.  B.  Co. : 

Liabilities  Assets 

Capital  Stock $14,000         Plant $10,000 

Accounts  Payable 3,000         Machinery 4,000 

Surplus 1,000         Merchandise 3,000 

Cash 1.000 


$18,000  $18,000 

Classification  of  Assets. — The  subdivision  and  classification 
of  the  assets,  liabilities  and  proprietary  accounts  are  important 
problems.  Upon  them  the  value  of  the  balance  sheet  is  largely 
dependent.  The  consideration  of  a  going  concern  will  disclose 
certain  general  classes  of  assets  essential  to  its  existence,  and 
perhaps  some  of  a  less  essential  character.  First  in  ^mount  and 
importance  usually  come  the  fixed  assets,  consisting  of  land, 
buildings,  and  permanent  investments,  if  any.  In  general,  the 
fixed  assets  are  those  of  a  permanent  character  with  an  expecta- 
tion of  a  lifetime  frequently  of  many  years — possibly  perpetual, 
as  in  case  of  land.  In  a  sense,  we  cannot  say  that  fixed  assets 
are  absolutely  more  important  than  those  of  a  less  permanent 
character,  yet  they  usually  constitute  a  large  proportion  of  the 
entire  investment,  and  necessitate  a  continuous  and  heavy  upkeep 
expenditure. 

A.  Lowes  Dickinson'  suggests  a  threefold  subdivision  of  the 
more  important  forms  of  invested  capital  into  (1)  fixed  assets,  (2) 
permanent  investments,  and  (3)  investment  of  reserves.  If  such 
a  detailed  subdivision  in  the  balance  sheet  is  thought  necessary 
the  above  classification  is  a  good  one.     Fixed  assets  include  the 

'  Accounting  Practice  and  Procedure,  p.  38. 
14 


210  ACCOUNTS  IN   THEORY  AND  PRACTICE 

various  permanent  tangible  properties  as  well  as  goodwill, 
franchises,  and  patent  rights.  By  permanent  investments  is 
meant  those  which  are  held  for  the  income  produced  by  them  or 
for  purposes  of  control  of  subsidiary  companies.  They  should 
be  distinguished  carefully  from  temporary  investments  made 
for  the  purpose  of  turning  idle  funds  to  some  profit.  Investment 
of  reserves  would  include  all  funds  set  aside  for  specified  purposes, 
such  as  bond  sinking  funds,  funds  intended  for  future  extensions, 
and  so  on. 

Working  and  Current  Assets. — Next,  a  suitable  classification 
must  be  made  of  the  assets  of  a  less  permanent  character,  such  as 
cash,  merchandise,  accounts  and  notes  and  acceptances  receiv- 
able, and  so  on.  Accountants  sometimes  make  a  twofold  classi- 
fication of  this  division,  namely,  working  and  current,  although 
the  division  hne  between  these  is  not  always  distinct.  As  a 
consequence  the  word  "current"  has  been  employed  by  some  to 
include  working  assets.  Generally,  however,  a  distinction  ought 
to  be  made  between  working  and  current  assets.  Unlike  cash  or 
accounts  receivable  they  are  not  free  to  be  spent  or  liquidated, 
but  they  are  to  be  used  in  the  process  of  doing  business.  They 
include  raw  materials  and  supplies,  and  if  we  follow  the  authority 
of  Dickinson,  various  expenses  paid  in  advance  of  the  time  to 
which  they  are  incident,  such  as  insurance,  taxes  and  royalties. 

Current  assets,  on  the  other  hand,  are  cash  and  those  assets 
convertible  into  cash  in  the  near  future  without  any  significant 
alteration  in  their  form  or  character.  By  a  significant  alteration 
in  form  or  character  is  meant  one  which  requires  time  and  expense 
to  perform.  Thus  the  conversion  of  raw  material  into  finished 
product  is  a  significant  alteration.  But  the  acceptance  of  a 
note  for  an  open  account  is  not  a  significant  alteration.  Working 
assets  are  permanent  only  as  a  class  and  thus  are  to  be  distinguished 
from  fixed  assets  which  are  permanent  as  individual  units. 

Current  assets  likewise  are  permanent  only  as  a  class,  but  they 
are  to  be  distinguished  from  working  assets  by  the  fact  that  they 
are  either  in  form  of  cash  or  else  convertible  into  cash  without  first 
undergoing  a  significant  alteration.  The  chief  purpose  of  the 
working  assets  is  to  further  the  process  of  production.  The 
chief  purpose  of  current  assets  is  to  provide  a  fund  for  the  pay- 
ment of  liabilities  as  they  fall  due.  If  the  working  assets  may 
be  said  to  represent  a  stage  in  the  business  cycle  then  the  current 
assets  represent  the  next  stage  in  the  cycle. 


THE  BALANCE  SHEET  211 

The  distinction  between  working  and  current  assets  is  not 
always  an  absolute  one;  nevertheless  it  is  justified  if  it  makes 
possible  a  better  comprehension  of  the  relative  position  and  sig- 
nificance of  the  elements  constituting  these  two  groups.  For 
instance,  in  interpreting  the  balance  sheet  we  customarily  make 
a  comparison  of  the  assets  and  the  habilities  in  order  to  determine 
not  merely  the  absolute  solvency  of  the  concern,  but  also  its 
relative  ability  to  meet  its  accruing  liabihties.  In  doing  this  we 
set  the  cash  and  assets  that  are  easily  liquidated  over  against 
the  current  habilities,  making  due  allowance  for  the  time  required 
to  h  qui  date  the  assets  and  for  the  time  the  various  liabihties 
run.  Evidently,  for  such  purposes  it  is  desirable  to  make  a 
distinction  between  those  assets  that  are  held  with  the  object 
of  employing  them  in  the  processes  of  production  and  those  that 
are  in  a  form  which  permits  of  their  immediate  or  prospective 
use  for  payment  of  debts. 

Briefly,  the  functions  of  working  and  current  assets  are  differ- 
ent, and  in  any  case  the  division  of  the  assets  into  one  class  or 
the  other  ought  not  to  be  made  arbitrarily  but  on  the  basis  of 
the  function  they  happen  to  perform. 

Deferred  Charges. — With  assets  classified  as  fixed,  working 
and  current,  it  is  still  impossible  to  include  under  any  of  these 
three  heads  certain  more  or  less  common  items.  These  are 
variously  termed  deferred  charges,  deferred  assets,  deferred 
charges  to  income,  and  suspense  debits.  However,  these  terms 
are  not  always  employed  synonymously,  for  they  admit  of  two 
possible  interpretations.  As  reserves  are  divided  into  valuation 
reserves  and  reserves  of  profit,  so  deferred  charges  represent 
either  actual  value  or  merely  expense  which  is  to  be  distributed 
over  future  accounting  periods  on  some  equitable  basis. 

What  is  the  function  of  this  class  of  items?  Klein'  says  de- 
ferred assets  "consist  of  expense  items  not  yet  consumed  or 
used  up."  Hatfield'^  says  of  deferred  charges  that  they  "indicate 
that  payment  has  been  made  of  expenses  properly  belonging  to  a 
period  subsequent  to  the  date  of  the  Balance  Sheet."  Dickinson' 
says  that  "suspense  debits  represent  no  value  and  must  sooner  or 
later  be  written  off  entirely  as  losses  or  expenses."  A  discrepancy 
exists  between  the  contentions  of  Hatfield  and  Klein  on  the  one 

'  Elements  of  Accounting,  p.  165. 

'  Modern  Accounting,  p.  113. 

*  Accounting  Practice  and  Procedure,  p.  41. 


212  ACCOUNTS  IN  THEORY  AND  PRACTICE 

hand  and  of  Dickinson  on  the  other.  From  the  first  two  quota- 
tions cited  we  infer  that  this  particular  class  of  balance  sheet 
accounts  represents  value  because  they  represent  expenses  "  prop- 
erly belonging  to  a  period  subsequent  to  the  date  of  the  Balance 
Sheet"  and  because  they  are  "not  yet  consumed  or  used  up." 
In  the  last  quotation  cited  we  are  told  that  they  "represent  no 
value."  The  only  possibility  of  reconcihng  these  statements  is  to 
assume  that  Dickinson's  phrase,  "suspense  debits,"  is  employed 
in  a  different  sense  than  that  attached  to  "deferred  charges"  by 
Klein  and  Hatfield. 

Dickinson  (p.  34)  includes  among  working  assets  "insurance, 
interest,  taxes,  royalties,  etc."  paid  in  advance,  thus  greatly 
narrowing  the  range  of  his  charges  to  "suspense  debits;"  so 
that  about  the  only  items  that  remain  within  the  field  covered 
by  his  "suspense  debits"  are,  discount  on  bond  issues,  organiza- 
tion expenses,  and  certain  other  extraordinary  expenses.  Thus 
limited,  this  account  probably  corresponds  to  Dickinson's  defi- 
nition. In  the  more  inclusive  sense  deferred  charges  represent 
real  asset  value — any  kind  of  legitimate  expense  incurred  in  ad- 
vance of  the  time  when  it  actually  accrues  as  an  expense. 

Why  should  expenses  paid  in  advance  be  considered  working 
assets?  Insurance,  interest  and  taxes  are  expenses  of  a  general 
character  and  at  most  only  a  certain  proportion  of  them  enter  into 
the  cost  of  the  product.  Moreover,  they  are  distributed  as 
indirect  cost  or  burden,  not  as  direct  elements  of  cost.  There  is 
no  assurance  as  to  what  proportion  of  them  will  ever  be  absorbed 
as  indirect  and  what  part  may  ultimately  find  its  way  to  profit 
and  loss  as  a  part  of  undistributed  burden  or  as  an  administration 
expense.  The  better  way  is  to  show  such  items  as  deferred  assets 
and  then  make  their  distribution  to  cost  of  product,  or  otherwise, 
as  they  accrue.  Sometimes  payments  are  made  in  advance  to 
cover  a  very  considerable  period  and  the  impropriety  of  including 
such  charges  in  working  assets  is  apparent. 

CAPITAL  AND  SURPLUS 

Capital  and  surplus  together  represent  the  proprietorship  or 
interest  of  the  stockholders.  The  word  capital  here  refers  to  the 
par  value  of  outstanding  capital  stock,  although  it  is  sometimes 
used  more  comprehensively  as  including  both  capital  stock  and 
surplus.     The  stockholders'  interests  as  measured  by  the  market 


THE  BALANCE  SHEET  213 

value  of  their  stocks  may  not  correspond  to  their  interests  meas- 
ured in  terms  of  the  book  accounts  for  capital  stock  and  surplus. 
Capital  stock  and  surplus  are  considered  separately  for  technical 
and  legal  reasons  although  they  represent  one  thing — the  equity 
of  the  stockholders. 

Liability  on  Capital  Stock. — By  law,  the  purchaser  of  capital 
stock  at  par  is  reheved  of  any  further  obligation  upon  it.  In  fact, 
even  when  stock  is  full  paid,  certain  possibilities  accompany  it 
which,  though  they  may  not  take  the  form  of  compulsory  re- 
quirements, do  lead  to  further  payments.  For  example,  if  a 
corporation  is  unable  to  meet  the  interest  on  its  bonded  indebted- 
ness the  stockholders  may  be  given  the  choice  of  paying  an 
assessment  of  so  much  per  share  or  of  losing  control  of  the 
company. 

The  Trust  Fund  Theory. — The  law  regards  money  or  other 
valuable  consideration  received  for  capital  stock  issued  as  a  fund 
held  in  trust  for  the  protection  of  the  corporation's  creditors. 
This  fund  must  be  zealously  guarded  and  its  disposition  limited 
to  legitimate  uses.  It  is  for  this  reason  that  the  payment  of 
dividends  out  of  capital  is  prohibited  and  the  directors  held 
personally  responsible  for  them.^  It  has  been  held  in  Connecti- 
cut that  as  the  stock  of  a  company  is  the  only  basis  of  credit, 
its  capital  stock  is  to  be  regarded  as  a  trust  fund  to  which  the 
claims  of  creditors  precede  those  of  stockholders.^  There  are, 
however,  some  exceptions  to  the  rule  which  has  prohibited  the 
payment  of  dividends  out  of  capital.  Moreover,  additions  to 
surplus  are  sometimes  made  from  such  sources  that  it  becomes  a 
question  whether  or  not  they  represent  profit  distributable  as 
dividends.     Let  us  consider  some  of  these  cases. 

Capital  Invested  in  Wasting  Assets. — In  the  first  place  a  dis- 
tinction must  be  made  between  companies  whose  capital  is  in- 

•Crandall  et  al.,  Receivers,  vs.  Lincoln,  52  Conn.  73.  Al.so,  Bush,  Trus- 
tee, vs.  Ro.ss,  68  Conn.  29. 
Section  5  of  the  corporation  of  Connecticut,  provides: 
"No  corporation  shall  pay  any  dividend  or  make  any  other  distribution 
of  its  assets  except  from  its  net  profits  or  actual  surplus,  unless  in  accord- 
ance with  the  law  allowing  the  reduction  of  stock,  or  upon  the  dissolution 
of  the  corporation.  .  .  If  such  payment  or  distribution  renders  a  cor- 
poration in-solvent,  the  directors  so  voting  .shall  be  jointly  and  severally 
liable,  to  the  amount  so  paid  or  distributed,  to  any  creditors  existing  at 
the  date  of  such  vote  who  shall  obtain  judgment  against  such  corporation 
on  which  execution  shall  be  returned  unsatisfied." 


214  ACCOUNTS  IN   THEORY  AND  PRACTICE 

vested  in  wasting  assets  and  those  whose  capital  is  invested  in 
permanent  assets.  In  a  sense,  of  course,  all  assets  are  wasting, 
but  as  here  used  the  term  refers  only  to  a  special  class — those 
which  must  be  consumed  in  the  process  of  exploitation,  such  as 
iron  ore  beds,  gold  deposits,  and  so  on.  "Permanent,"  on  the 
other  hand,  signifies  assets  which,  even  though  they  depreciate, 
can  be  repaired  and  replaced  and  thus  be  retained  at  something 
like  their  original  value.  A  coal  deposit  cannot  be  replaced. 
It  follows  that  the  Hfe  of  a  concern  engaged  in  the  exploitation 
of  a  wasting  asset  is  strictly  limited  by  the  quantity  of  that  asset, 
while  one  whose  work  consists  in  manufacturing,  transportation 
or  trading  is  not  so  limited,  but  may  continue  indefinitely  in 
operation  by  making  due  allowance  for  repairs  and  replacement 
of  plant. 

The  question,  then,  is,  must  the  same  principle  respecting  the 
integrity  of  capital  invested  hold  for  both  classes  of  companies, 
say,  for  a  mining  company  as  well  for  a  manufacturing  company? 
There  is  little  doubt  that,  from  a  theoretical  point  of  view,  no  dis- 
tinction ought  to  be  made.  But  certain  practical  considerations 
intervene.  In  the  first  place,  a  company  engaged  in  the  exploi- 
tation of  a  wasting  asset  must  pursue  a  somewhat  different  policy 
in  the  construction  and  maintenance  of  its  plant  than  one  which 
has  the  prospect  of  continuous  existence.  It  may  not  be  advisa- 
ble to  build  as  well  or  to  continue  making  repairs  and  replace- 
ments beyond  a  point  in  time  which  will  be  determined  by  the 
prospective  life  of  the  wasting  assets.  As  the  time  of  exhaustion 
of  a  mineral  deposit  approaches  it  would  be  inadvisable  to  continue 
making  any  more  repairs  to  the  buildings  and  machinery  than 
would  be  required  to  keep  up  operating  efficiency  to  a  normal 
point.  To  continue  making  repairs  and  replacements  as  if 
upon  the  assumption  that  the  plant  is  to  continue  operating 
indefinitely  would  mean  that  when  the  point  of  exhaustion  is 
reached  a  highly  repaired  and  efficient  plant  would  remain  with- 
out any  work  to  perform  and  therefore  become  a  heavy  loss; 
whereas  if  only  such  repairs  are  made  as  are  absolutely 
essential  the  loss  represented  by  the  defunct  establishment  is 
much  less. 

Exhaustion  of  Wasting  Assets. — Even  though  the  plant  and 
machinery  about  a  mine  are  kept  in  a  high  state  of  repair  and 
their  normal  depreciation^  is  fully  covered  by  reserves,  the  miner- 

1  See  Saliers:  Principles  of  Depreciation,  p.  25,  for  a  discussion  of  normal 
or  average  depreciation. 


THE  BALANCE  SHEET  215 

als  will  be  exhausted  finally  and  the  investment  in  the  form  of  the 
purchase  money  paid  for  them  as  they  lay  in  situ  will  have 
vanished — unless  some  provision  for  this  depletion  is  made  in  the 
form  of  a  sinking  fund  which  accumulates  approximately  at 
the  rate  that  the  value  of  the  mineral  in  situ  decreases  from 
exploitation.  This  is  the  only  possible  arrangement  by  which 
the  capital  can  be  kept  in  tact  as  a  fund  for  the  protection  of 
creditors. 

The  Sinking  Fund. — The  deed  of  trust  securing  the  bonds  of 
such  companies  usually  makes  provision  to  the  effect  that  for  each 
unit  of  product  exploited  a  given  amount  shall  be  set  aside  in 
the  hands  of  a  trustee  as  a  sinking  fund  to  replace  wasting  assets. 
The  amount  of  such  deposit,  however,  is  usually  conditioned, 
not  upon  the  total  investment,  but  upon  the  portion  of  the 
investment  represented  by  bonded  indebtedness.  It  appears 
that  so  far  as  bondholders  are  concerned  this  plan  offers  them  the 
desired  protection.  It  does  not  appear,  however,  that  it  would 
be  necessary  to  preserve  in  tact  the  whole  original  investment. 
That  part  repre.sented  by  fully  paid  up  stock  might  be  permitted 
to  deteriorate  in  value  through  a  process  of  dividend  payment  by 
which  not  only  the  current  profits  but  also  a  part  of  capital  would 
be  returned  to  the  stockholders.^ 

Unproductivity  of  Investments. — Nevertheless,  capital  must 
not  be  distributed  in  disregard  of  the  rights  of  creditors.  But 
when  provision  has  been  made  for  their  protection  the  policy 
to  be  followed  respecting  a  further  retention  of  capital  would 
appear  to  be  a  matter  of  expediency  so  long  as  its  effect  is  not 
obscured  by  incorrect  accounting.  The  objection  to  the  reten- 
tion of  assets  equivalent  to  the  original  investment,  in  the  case 
of  a  concern  whose  original  possessions  consisted  in  part  of 
wasting  assets,  is  that  these  assets  must  take  the  form,  to  a  con- 
siderable extent,  of  investments  which  are  liable  to  prove  to  be 
rather  unproductive.  As  cash  accumulates  in  the  fund  estab- 
lished to  compensate  the  loss  resulting  from  exhaustion  of  wasting 
assets  it  must  be  invested  after  the  usual  method  of  handling 
sinking  funds.  But  sinking  funds  are  notoriously  unproductive, 
and  to  gradually  transfer  the  capital  invested  in  the  more  profit- 
able field  of  active  endeavor  to  the  less  profitable  one  of  an  invested 

'  See  Hatfield:  Modern  Accounting,  Chap.  XI,  for  a  consideration  of  court 
decisions  on  dividends  paid  from  capital. 


216  ACCOUNTS  IN  THEORY  AND  PRACTICE 

fund  does  not  appear  to  be  a  justifiable  plan,  except  in  so  far  as 
it  is  necessary  for  the  protection  of  creditors. 

Protection  Required  for  Creditors. — Hence  to  say  that  the  whole 
original  investment  must  be  kept  in  tact  as  a  trust  fund  for  the 
protection  of  creditors  is  imposing  a  restriction  upon  the  stock- 
holders which  may  not  be  desirable.  Creditors  must  be  pro- 
tected to  the  extent  of  their  loan  but  not  to  the  extent  of  twice 
or  thrice  its  amount.'  In  Connecticut,  by  a  two-thirds  vote  of 
the  stockholders,  the  capital  stock  may  be  reduced  as  much  as 
desirable  so  long  as  the  company  is  not  thereby  rendered  insolvent. 
If  it  is  thus  rendered  insolvent,  the  stockholders  voting  in  favor 
of  such  reduction  are  held  liable,  jointly  and  severally,  for  all 
debts  that  may  remain  unsatisfied.  From  this  we  infer  that  the 
capital  stock  may  be  regarded  as  a  trust  fund  for  protection  of 
creditors  only  to  the  extent  of  such  indebtedness.  Beyond  this 
it  rests  with  the  stockholders  themselves  to  say  what  they  will  do 
with  their  capital. 

Permanent  Corporations. — Outside  the  ranks  of  corporations 
engaged  in  the  exploitation  of  wasting  assets  the  question  of  the 
preservation  of  the  invested  capital  is  essentially  different.  A 
mining  company  is  most  prosperous  when  its  assets  are  being 
most  rapidly  consumed.  With  a  manufacturing  company  con- 
ditions are  different.  Its  supply  of  raw  material  is  continually 
replenished  from  without  and  ordinarily  there  is  no  question 
about  the  preservation  of  this  supply.  The  raw  materials  are 
not  usually  bought  up  in  large  quantities  in  advance  but  as  they 
are  required.  So  there  is  no  large  initial  investment  in  raw 
materials.  A  mining  company  buys  its  raw  material  in  advance. 
It  is  as  if  a  manufacturer  of  shoes  were  to  buy  up  enough  leather 
to  last  for  thirty  years  with  the  expectation  of  discontinuing 
business  when  this  supply  gives  out. 

Instead,  the  shoe  manufacturer  purchases  his  raw  materials 
as  he  needs  them,  and  as  the  supply  of  them  is  continuous  he  has 
no  intention  of  going  out  of  business  at  all.  His  depreciation 
problem  is  a  different  one.  His  plant  is  permanent  and  provision 
must  be  made  for  its  permanent  upkeep.  He  makes  repairs  and 
replacements  with  the  assurance  that  the  money  spent  upon 
them  will  not  be  lost  through  the  discontinuance  of  operations 
at  some  future  time,  but  that  it  will  be  fully  returned  through  the 
endless  process  of  manufacture. 

*  Not  limited  to  corporations  engaged  in  exploiting  wasting  assets. 


THE  BALANCE  SHEET  217 

If  wasting  assets  are  being  exploited  the  procedure  will 
therefore  consist  in  (a)  preservation  of  capital  to  the  extent  that 
may  be  necessary  for  the  protection  of  creditors,  this  capital 
preferably  taking  the  form  of  special  funds  created  on  a  basis  of 
output,  as  so  much  per  ton  mined,  etc. ;  (6)  distribution  of  capital 
to  stockholders  when  it  can  be  more  profitably  employed  by  them 
than  by  the  company,  due  allowance  being  made  for  (a)  above 
and  for  the  running  requirements  of  the  plant. 


CHAPTER  XXXIII 

CONSTRUCTION  AND  INTERPRETATION  OF  THE 
BALANCE  SKEET— (Continued) 

Balance  Sheet  Illustrations. — Any  such  diminution  of  the 
original  investment  as  that  suggested  at  the  close  of  the  pre- 
ceding chapter  ought  to  be  honestly  and  accurately  reflected  in 
the  balance  sheet.  Not  only  must  present  creditors  be  pro- 
tected but  prospective  creditors  as  well  must  not  be  misinformed 
about  the  worth  of  the  company's  assets.  To  illustrate,  assume 
that  the  following  balance  sheet  indicates  accurately  the  condi- 
tion of  the  Superior  Mining  Company  on  the  day  it  begins  busi- 
ness: 

Balance  Sheet,  Superior  Mining  Company : 

Wasting  Assets $100,000         Capital  Stock $100,000 

Plant 20,000         Bonds  (20  years) 35,000 

Machinery 10,000 

Cash 5,000  

$135,000  $135,000 

» — 

Assume,  further,  that  at  the  end  of  ten  years  it  is  estimated  that 
the  wasting  assets  are  one-half  exhausted,  and  that  a  fund  has 
been  set  aside  to  cover  this  exhaustion,  that  reserves  have  been 
set  up  to  cover  depreciation  of  plant  and  machinery,  and  that 
other  accounts  undergo  no  change.  The  balance  sheet  then 
appears  thus: 

Balance  Sheet,  Superior  Mining  Company : 

Wasting  Assets $100,000  Capital  Stock $100,000 

Less  Reserve  for  Depletion    50,000         50,000  Bonds   (20  years).       35,000 

Plant $20,000 

Less  Reserve  for  Deprecia- 
tion         8,000  12,000 

Machinery $10,000 

Less  Reserve  for  Deprecia- 
tion         5,000  5,000 

2  IS 


THE  BALANCE  SHEET  219 


Funds 

For  wasting  Assets $50,000 

For  Plant 8,000 

For  Machinery 5,000         63,000 

Cash 5,000 


$135,000  $135,000 


This  balance  sheet  has  been  drawn  up  according  to  the  assump- 
tion that  the  entire  original  investment  must  be  preserved.  No 
capital  has  been  distributed  as  dividends.  Suitable  reservat'ons 
have  been  made  for  depletion  of  wasting  assets  and  for  deprecia- 
tion of  plant  and  machinery.^  The  amounts  thus  reserved  have 
been  set  aside  as  special  funds,  as  shown.  An  examination  of 
this  balance  sheet  discloses  the  fact  that  the  assets  are  worth 
$135,000,  or  nearly  four  times  the  amount  of  the  outstanding 
bonds.  Must  the  total  value  of  these  assets  be  regarded  as  a 
trust  fund  for  the  protection  of  the  bondholders?  Would  not 
this  be  placing  too  severe  a  construction  upon  the  trust  fund 
theory?  Why  should  a  larger  trust  fund  be  required  for  the 
protection  of  the  bondholders  than  could  reasonably  be  required 
for  security  on  an  ordinary  loan?  A  bank  would  be  willing  to 
loan  $35,000  upon  collateral  security  consisting  of  about  $40,000 
first  grade  government  bonds  or  about  $45,000  in  high  grade  rail- 
road bonds. 

If  adequate  security  is  afforded  to  all  creditors,  either  in  the 
form  of  sinking  funds  in  the  hands  of  trustees  or  of  liens  upon 
specific  assets,  this  is  all  the  protection  that  could  reasonably  be 
asked.  Let  us  assume  that  the  Superior  Mining  Company  pur- 
sued a  different  plan  than  that  outlined  above,  and  that  after 
making  a  due  allowance  per  unit  of  mineral  mined  for  the  estab- 
lishment of  a  bond  sinking  fund  and  due  allowance  for  the  depre- 
ciation of  its  plant  and  machinery,  it  paid  out  the  balance  of 
revenues  as  dividends.  Assume  also  that  the  allowance  made  for 
the  estabhshment  of  a  sinking  fund  now  (at  the  end  of  ten  years) 
amounts  to  $20,000,  which  is  adequate  since  but  one-half  of  the 
minerals  are  estimated  to  have  been  removed.  As  a  conse- 
quence of  this  policy  the  balance  sheet  at  the  end  of  ten  years 
appears  thus : 

'  The  word  "depletion"  is  very  properly  employed  to  distinguish  the  ex- 
haustion of  wasting  assets  from  the  depreciation  of  plant,  etc. 


220  ACCOUNTS  IN   THEORY  AND  PRACTICE 


Balance  Sheet,  Superior  Mining  Company : 

Wasting  Assets $100,000  Capital  Stock. ..  .   $100,000 

Less  Depletion 50,000  Bonds  (20  yrs.) . .       35,000 

$50,000 

Plant $20,000 

Less  Reserve  for   De-  8,000 

preciation  12,000 

Machinery.. $10,000 

Less  Reserve  for  Depre- 
ciation          5,000 

5,000 

Funds 

For  Plant $8,000 

For  Machinery 5,000 

For  Bonds 20,000         33,000 

Cash 5,000 

Deficit  (due  to  payment  of 

dividends  from  capital).  30,000 

$135,000  $135,000 


This  balance  sheet  shows  the  results  of  the  payment  of  divi- 
dends from  capital.  No  provision  has  been  made  for  the  deple- 
tion of  wasting  assets.  The  only  item  which  tends  to  compensate 
for  the  decrease  in  value  of  wasting  assets,  amounting  to  $50,000, 
is  the  bond  sinking  fund  of  $20,000,  which  has  been  reserved  out 
of  income.  This  gives  adequate  protection  to  the  bondholders 
providing  this  money  is  placed  in  the  care  of  an  independent 
trustee.  To  require  the  corporation  to  retain  the  full  original 
equity  of  its  capital  stock  by  reserving  out  of  revenues  an  amount 
equal  in  value  to  the  deposits  that  are  exhausted  would  mean 
that  the  corporation  would  be  gradually  transformed  from  a 
mining  to  an  investment  institution,  and  as  the  last  years  of 
the  company's  existence  as  a  mining  corporation  approached  it 
would  find  a  very  large  proportion  of  its  capital  tied  up  in  invest- 
ments which  would  be  either  unsafe  in  character  or  else  very 
unproductive. 

Profits  Distributable  as  Dividends. — Aside  from  enterprises 
engaged  in  the  exploitation  of  wasting  assets,  it  is  the  rule  to 
make  full  provision  for  all  losses  from  depreciation.  The  con- 
tinued efficiency  of  the  concern  requires  this.  But  important 
questions  arise  concerning  the  nature  of  profits  and  increments 


THE  BALANCE  SHEET  221 

of  capital  from  various  sources.  It  is  generally  acknowledged 
that  bona  fide  profits  resulting  from  ordinary  operations  are  dis- 
tributable as  dividends.  Owing  to  the  complex  nature  of 
business  this  matter  frequently  becomes  complicated,  as  the 
following  considerations  will  indicate: 

1.  In  determining  whether  there  is  a  distributable  surplus  of 
profits  must  we  consider  each  year  as  a  unit  by  itself  or  must  any 
losses  incurred  during  previous  years  first  be  made  up?  A  period 
of  inactivity  might  leave  a  corporation  with  a  deficit  of  $50,000. 
Then  might  follow  a  year  during  which  a  net  profit  of  $40,000  is 
made.  Must  this  profit  be  employed  to  reduce  the  previously 
accumulated  deficit  or  may  it  be  distributed  as  dividends? 

2.  Assets  sometimes  appreciate  in  value  due  to  community 
growth,  and  so  on.  Should  such  increments  of  wealth  be  con- 
sidered as  profits;  if  so,  are  such  profits  distributable  as  divi- 
dends? 

3.  Shares  of  stock  are  sometimes  sold  at  a  premium.  If  a 
corporation  disposes  of  stock  at  a  premium,  is  that  premium  to 
be  considered  as  profit  distributable  as  dividends  or  is  it  a  part 
of  capital  and  not  distributable? 

Each  Year  not  a  Unit. — As  to  the  first  proposition,  there  is 
little  to  justify  the  theory  that  each  year  is  a  unit  to  be  consid- 
ered without  reference  to  the  ones  preceding  it.  To  carry  such 
a  plan  to  its  logical  conclusion  would  be  equivalent  to  a  denial  of 
the  integrity  of  the  invested  capital  and  make  uncertain  its 
amount  and  stability.  If  each  year  in  which  a  deficit  occurs  is 
permitted  to  make  inroads  into  capital,  and  if  nothing  is  reserved 
during  fat  years  to  make  up  these  deficits,  then  with  every  year 
in  which  there  occurs  a  deficit  there  will  result  a  reduction  of 
the  investment.  An  accumulation  of  such  deficits  would  ulti- 
mately lead  to  insolvency. 

Alt-hough  some  court  decisions  have  thrown  doubt  upon  the 
manner  in  which  the  situation  suggested  above  should  be  handled, 
the  general  principle  that  should  govern  is  clear,  namely,  that 
with  the  exception  of  companies  engaged  in  exploiting  wasting 
assets,  capital  must  be  kept  in  tact  by  making  up  the  deficits  of 
poor  years  from  the  gains  of  prosperous  years.  This  rule  must  be 
employed  with  reason,  however.  Good  accounting  "averages 
up"  good  and  bad  years  and  tries  to  make  possible  some  consist- 
ent kind  of  dividend  payment.  It  might  be  better  to  remove 
an  extraordinary  deficit  by  writing  it  off  over  a  series  of  years, 


222  ACCOUNTS  IN   THEORY  AND  PRACTICE 

rather  than  by  a  drastic  recision  of  all  dividend  payments  for  a 
single  year.' 

Profit  on  Appreciated  Property. — As  to  the  second  proposition, 
whether  appreciation  of  property  due  to  influences  beyond  the 
control  of  the  company  may  be  made  the  basis  of  a  distribution 
of  profits,  it  is  generally  conceded  that  until  such  appreciated 
value  is  actually  realized  by  sale  it  should  not  be  considered  as  a 
profit  and  so  cannot  be  distributed  as  such.  When  the  profit  is 
actually  realized  by  sale  there  appears  to  be  no  objection  to  its 
distribution  as  dividends,  although  conservative  management 
might  retain  it  as  a  permanent  addition  to  surplus. 

Premium  on  Capital  Stock. — Proposition  three.  When  shares 
of  stock  are  sold  at  a  premium  the  excess  received  above  the  par 
of  the  shares  is  credited  to  an  account  usually  known  as  the 
premium  on  stock  account.  Concerning  the  possible  procedure 
here  authorities  differ  greatly.  Some  maintain  that  this  pre- 
mium, even  though  it  may  be  viewed  as  a  profit,  is  one  which 
ought  not  to  be  distributed  as  dividends.  Others  assert  that  it 
is  not  a  profit  at  all  and  that  to  consider  it  as  such  places  a  cor- 
poration in  a  culpable  situation.  ^  On  the  other  hand  authorities 
are  not  wanting  who  justify  the  distribution  of  such  a  premium 
on  stock  as  a  dividend.  On  July  14,  1914,  the  New  York  court 
of  appeals,  in  the  case  of  Equitable  Life  Assurance  Society  vs. 
Union  Pacific  Railroad  Company^  took  this  view.  The  Equitable 
Life  Assurance  Society  sought  to  restrain  the  railroad  company 
from  paying  an  extraordinary  dividend  from  surplus  acquired  in 
part  by  the  sale  of  stock  at  a  premium.  Note  the  following  quota- 
tion from  this  decision: 

New  York  Case  Cited. — "It  is  said,  because  in  the  retirement  of  its 
convertible  bonds  defendant  sold  and  issued  its  capital  stock  at  $175 
per  share  of  $100  par  value,  that  this  entire  sum  was  paid  in  as  capital 
and  must  be  held  and  distributed  as  such.  That  is  not  my  interpre- 
tation of  the  transaction  under  the  allegations  of  the  complaint.  The 
amount  at  par  value  paid  for  each  share  of  stock  undoubtedly  became 
capital,  which  the  corporation  was  required  to  preserve  and  maintain 

'  For  a  discussion  of  some  English  and  American  court  decisions  touching 
on  this  matter,  see  Hatfield:  Modern  Accounting,  pp.  205-213. 

^  For  various  interpretations  of  this  view  consult  Hatfield :  Modern 
Accounting,  pp.  155,  234;  Esquerr^,  Applied  Theory  of  Accounts:  p.  330; 
Bennett:  Corporation  Accounting,  p.  88;  and  Montgomery:  Auditing  Theory 
and  Practice,  2nd  ed.,  1916,  p.  194. 

»  N.  E.  Rep.  vol.  106,  p.  92. 


THE  BALANCE  SHEET  223 

as  against  its  liability  on  the  outstanding  share  of  stock  which  had  been 
issued  for  it.  Just  as  undoubtedly  the  extra  $75  paid  per  share  repre- 
sented the  amount  of  accumulated  profits  or  surplus  which  it  was  sup- 
posed would  be  apportionable  to  each  share  of  new  stock  after  payment 
and  issue  as  aforesaid.  .  .  When  paid  in  this  premium  became  part 
of  such  accumulation  of  profits  and  surplus  and  distributable  as  such. 
It  was  credited  to  profit  and  loss  and  not  to  capital.  .  ."  Also: 
•'When  a  corporation  has  a  surplus,  whether  a  dividend  shall  be  made, 
and  if  made  how  much  it  shall  be,  and  when  and  where  it  shall  be  pay- 
able, rest  in  the  fair  and  honest  discretion  of  the  directors  uncontrollable 
by  the  courts." 

Briefly,  as  stated,  the  premium  is  "for  the  purpose  of  equalizing 
as  between  new  and  old  stockholders,  their  respective  rights  in 
accumulated  profits"  which  presumably  are  distributable  as 
dividends.  In  other  words,  one  who  pays  above  par  for  stock 
because  there  is  a  distributable  surplus  back  of  it  ought  not  there- 
by to  be  prevented  from  the  receipt  of  dividends  out  of  such 
surplus.  Ordinarily  a  stockholder  is  thought  of  as  being  liable 
only  to  the  extent  of  the  par  value  of  his  shares,  in  case  of  in- 
solvency. If  his  shares  are  not  full  paid  he  can  only  be  made  to 
pay  the  difference  between  what  he  has  already  paid  and  the 
par  of  his  shares.  There  is  nothing  to  prevent  the  distribution 
of  surplus  accumulated  out  of  profits,  as  dividends,  whenever 
the  company  sees  fit.  To  illustrate,  let  the  following  balance 
sheet  represent  the  condition  of  a  corporation  at  a  given  time : 

Balance  Sheet: 

Fixed  Assets $100,000         Stock $100,000 

Current  Assets 50,000         Bonds 25,000 

Surplus 25  000 

$150,000  $150,000 

This  surplus  of  $25,000  may  or  may  not  be  distributed,  accord- 
ing to  the  judgment  of  the  board  of  directors.  If  it  is  distributed, 
the  equity  of  the  stockholders  will  be  reduced  from  $125  to  $100 
per  share  of  stock.  Consequently,  were  more  stock  to  be  sold  it 
would  be  reasonable  to  assume  that,  under  normal  conditions, 
it  would  go  for  about  par,  and  the  old  and  new  stockholders 
would  remain  on  a  parity.  If  it  is  not  distributed  the  new  stock 
would  probably  sell  for  about  $125  per  share,  since  the  old  stock- 
holders would  not  wish  new  stockholders  to  get  the  advantage 
of  the  old  equity  over  and  above  the  par  of  the  stock.     Suppose 


224  ACCOUNTS  IN  THEORY  AND  PRACTICE 

that  $100,000  of  new  stock  is  sold  at  125.  This  brings  the  sur- 
plus to  $50,000,  $25,000  of  which  is  accumulated  profits  and 
$25,000  premium  on  stock.  Suppose  further  that  this  $50,000 
is  distributed  as  surplus  to  the  stockholders. 

In  what  way  is  the  condition  of  the  company  different  from 
what  it  would  have  been  had  the  original  surplus  of  $25,000 
been  distributed  to  the  old  stockholders  before  the  sale  of  the 
new  stock,  which  would  then  have  been  made  at  par  or  there- 
abouts? In  no  way  whatever.  The  whole  affair  is  one  of 
policy  in  no  way  affected  by  the  rights  of  creditors.  This  view 
has  already  received  the  recognition  of  the  Interstate  Commerce 
Commission,  which  has  ruled  that,  "In  case  the  accounting  com- 
pany is  permitted  and  elects  to  distribute  all  or  any  part  of  the  net 
premium  on  its  capital  stock  to  its  stockholders,  the  amount  thus 
distributed  shall  be  charged  to  the  premium  account."^ 

Conclusion. — A  balance  sheet  should  be  so  constructed  that  the 
work  of  interpretation  will  be  aided,  as  far  as  possible,  by  its 
construction.  The  significance  of  the  balance  sheet  lies  in  the 
relationship  which  the  items  in  it  bear  to  one  another.  That 
relationship  ought  to  be  clarified,  not  obscured.  Although  very 
much  remains  to  be  done  in  the  way  of  systematization  in  bal- 
ance sheet  construction,  much  progress  has  been  made  toward 
standardization  in  form  and  terminology. 

BIBLIOGRAPHY 

Part  V.     Financial  Statements 

Bennett,   R.  J.     Corporation  Accounting.     New  York,    1916.     Chapter 

XXIV. 
Cole,  W.  M.     Problems  in  the  Principles  of  Accounting.     Cambridge,  1915. 
Oilman,  S.     Principles  of  Accounting.     Chicago,  1916.     Chapter  IV. 
Greendlinger,  L.     Accountancy  Problems,  Vols.  I  and  II.     New  York, 

1911. 
Greendlinger,  L.     Financial  and  Business  Statements.     New  York,  1917. 
Hatfield,  H.  R.     Modern  Accounting.     New  York,  1909.     Chapter  III. 
Klein,  J.  J.     Elements  of  Accounting.     New  York,  1913.     Chapter  IX. 
Saliers,  E.  a.     Financial  Statements  Made  Plain.     New  York,  1917. 

'  Classification  of  Income,  Profit  and  Loss  and  General  Balance  Sheet 
Accounts  for  Steam  Roads,  effective  July  1,  1914,  p.  39.  See  also  Uniform 
System  of  Accounts  for  Electric  Railways,  effective  July  1,  1914,  p.  75,  and 
Uniform  System  of  Accounts  for  Express  Companies,  effective  July  1,  1914, 
p.  73.  Apparently,  however,  the  Interstate  Commerce  Commission  favors 
the  retention  of  the  premium  on  stock  sold  until  offset  (1)  by  discounts  on 
sales  of  the  same  class  of  stock,  or  (2)  by  credits  to  profit  and  loss  upon 
the  reacquirement  of  the  stock.     See  references  noted  above. 


PART  VI 

SPECIAL  APPLICATIONS  OF  PRINCIPLES 

CHAPTER  XXXIV 
DEPARTMENT  ACCOUNTING 

Accounts  Locate  Responsibility. — One  of  the  main  objects  of 
an  accounting  system  is  to  enable  the  management  to  locate 
responsibility.  This  is  difficult  or  impossible  unless  we  have  a 
proper  kind  of  organization  in  charge  of  persons  upon  whom 
responsibility  can  be  definitely  placed.  When  an  enterprise  ex- 
pands beyond  a  certain  point  adequate  organization  is  usually 
possible  only  as  the  result  of  the  classification  of  its  activities 
on  a  departmental  basis.  The  size  and  character  of  the  depart- 
ments depend  upon  the  nature  of  the  business.  In  manufactur- 
ing, departments  are  established  for  the  performance  of  a  certain 
process  or  the  manufacture  of  certain  classes  of  commodities. 
In  merchandising,  departments  are  established  to  deal  in  certain 
classes  of  goods,  as  illustrated  by  the  ordinary  department  store. 
Purpose  of  Departments. — As  soon  as  a  business  is  departmen- 
talized it  is  no  longer  a  single  activity  but  a  group  of  activities 
united  by  a  single  ownership  and  control.  The  manager  of  such 
an  enterprise  must  be  able  not  only  to  show  what  results  are  being 
accomplished  by  the  concern  as  a  whole;  he  must  also  be  able  to 
distinguish  and  compare  the  results  accomplished  by  the  different 
departments.  Each  department  incurs  various  expenses,  con- 
sumes supplies,  and  must  be  charged  with  a  reasonable  propor- 
tion of  general  expenses  or  overhead,  such  as  result  from  salaries 
paid  to  general  officers,  taxes,  depreciation,  and  so  on.  If  a  con- 
cern is  properly  organized,  and  if  its  departments  are  definitely 
laid  out  and  responsibility  located,  an  adequate  accounting  sys- 
tem can  be  set  up.  If,  on  the  other  hand,  the  organization  is 
loose,  departments  without  definite  functions,  and  responsibility 
indefinite,  it  is  impossible  to  install  a  system  of  accounts  that  will 
give  valuable  results. 

16  225 


226  ACCOUNTS  IN   THEORY  AND  PRACTICE 

When  the  significance  of  departmentalization  is  fully  grasped 
it  will  be  seen  that  the  only  difference  between  an  accounting 
system  for  a  non-departmentalized  concern  and  one  for  a  de- 
partmentalized concern  lies  in  the  subdivision  of  the  accounts. 
Thus  if  a  merchant  who  has  kept  a  general  merchandise  estab- 
lishment wishes  to  organize  a  department  store  he  can  do  so  by 
classifying  his  merchandise  into  groups,  making  each  group  the 
basis  of  a  department.  For  example,  Department  A  might  be 
the  dry  goods  department,  Department  B  the  groceries  depart- 
ment. Department  C  the  hardware  department,  and  Depart- 
ment D  the  notions  department,  and  so  on.  Each  department 
may  be  compared  to  a  small  single-line  store.  The  number  of 
departments  will  vary  considerably  with  the  conditions  and  the 
desires  of  the  management  in  different  instances.  The  depart- 
ments mentioned  above  might  be  further  subdivided.  Depart- 
ment A-1  might  be  men's  clothing,  Department  A-2  women's 
clothing.  Department  A-3  children's  clothing,  and  so  on  ad 
infinitum. 

How  Accounts  are  Kept. — The  systematization  and  coordina- 
tion ctf  the  various  departments  are  accomplished  by  the  use  of 
columnar  Journals  and  controlling  accounts  with  subordinate 
Ledgers.  Such  a  system  must  be  both  accurate  and  practicable. 
A  single  Journal  with  two  columns,  one  for  charges  and  one  for 
credits,  might  be  accurate  but  it  would  be  impracticable,  for  a 
department  store.  Likewise  a  single  Ledger  might  be  accurate 
but  the  introduction  of  hundreds  of  personal  accounts  would 
make  it  impracticable.  Accounts  must  not  only  be  correct  in 
principle,  they  must  also  be  adaptable  to  specific  requirements. 
Such  systems  cannot  be  purchased  ready  made.  They  must  be 
contrived  to  fit  the  peculiar  conditions  that  characterize  an  enter- 
prise just  as  an  architect  draws  up  the  plans  for  a  building  only 
after  he  consults  both  his  customer's  needs  and  the  physical  sur- 
roundings of  the  location.  He  then  applies  the  general  princi- 
ples of  architecture  to  these  specific  conditions. 

Suppose  a  department  store  to  have  four  departments.  All 
purchases,  sales,  and  expenses  must  then  be  accounted  for  on  the 
basis  of  this  subdivision.  Each  department  is  considered  as  a 
unit  and  the  accounts  are  so  kept  that  all  purchases,  sales,  and 
expenses  incident  to  that  department  may  be  ascertained.  So 
far  as  possible,  therefore,  distinct  accounts  must  be  kept  for  each 
department,  while  those  expenses  which  cannot  be  charged  di- 


DEPARTMENT  ACCOUNTING  227 

rectly  to  the  different  departments  must  be  distributed  over  the 
departments  on  an  equitable  basis. 

A  purchases  account  is  kept  in  the  General  Ledger  for  each 
department.  Consequently  the  Purchases  Journal  should  have  a 
purchases  column  for  each  department,  which  may  be  headed 
Department  A,  Department  B,  and  so  on.  At  the  end  of  the 
month  the  totals  of  these  columns  are  posted  to  their  correspond- 
ing purchases  accounts  in  the  General  Ledger — Purchases,  De- 
partment A,  and  so  on.  If  the  accounts  payable  are  not  so 
numerous  but  that  they  can  be  easily  kept  in  one  subordinate 
Ledger,  then  the  totals  of  the  four  departmental  purchases  col- 
umns will  be  posted  to  the  credit  of  the  accounts  payable  con- 
trolling account.  A  sundry  column  in  the  Purchases  Book  will 
provide  for  the  reception  of  purchases  which  are  not  made  on  a 
departmental  basis.  Possibly  it  will  be  found  desirable  to  pro- 
vide a  miscellaneous  column  for  each  department  in  which  the 
purchases  of  things  other  than  commodities  may  be  recorded 
when  made  on  a  departmental  basis,  such  as  supplies,  etc. 

Possibly,  with  the  expansion  of  business,  it  may  be  desirable 
to  provide  a  separate  Purchases  Journal  for  each  department, 
with  columns  for  expenses  in  addition  to  the  one  for  merchandise 
purchases.  The  monthly  postings  from  these  would  be  made  in 
the  same  way  as  if  there  were  but  one  Purchases  Journal,  the 
proper  accounts  being  charged  in  the  General  Ledger  and  the 
controlling  accounts  payable  account  being  credited.  If  the 
Voucher  Register  is  used  columns  must  be  provided  in  it  for  the 
distribution  of  purchases  and  expenses  on  a  departmental  basis, 
whenever  such  a  direct  distribution  is  possible. 

Distribution  of  Indirect. — Probably  the  most  difficult  problem 
in  departmental  accounting  is  the  distribution  of  indirect,  or 
general  expenses,  among  the  various  departments  on  an  equitable 
basis.  These  expenses,  since  they  cannot  be  charged  directly 
to  the  departmental  expense  accounts,  must  first  be  charged  to 
"clearing  accounts."  Then,  at  the  end  of  the  month,  some  basis 
for  their  distribution  having  been  determined  upon,  the  clearing 
accounts  are  credited  and  charges  are  made  to  the  proper  depart- 
mental accounts.  Following  are  some  examples  of  such  general 
or  overhead  expenses: 

Insurance  Salaries  of  General  Officers 

Light  Rent 

Heat  Advertising 


228  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Basis  of  Distribution. — Possibly  one  or  more  of  these  may  be 
charged  directly  to  departmental  expense  accounts.  Thus  if  the 
lighting  arrangement  is  such  as  to  permit  the  use  of  separate  meters 
for  the  various  departments  Hght  expense  could  be  charged 
directly  to  departments,  and  so  on.  The  accountant's  problem 
is  to  find  an  equitable  basis  of  distribution  for  these  general 
expenses.  This  basis  will  vary  with  the  nature  of  the  expense. 
The  following  is  suggested  as  showing  the  procedure  to  be  fol- 
lowed : 

Name  of  Expense  Basis  of  Distribution 
Insurance  Value  of  property 
Interest  on  stock  (if  used)  Value  of  property- 
Light  Candle  power  required 
Heat  Cubic  feet  of  space 
Salaries  of  General  Officials  Sales 

Rent  Floor  space,  or  desirability  of  location 

Advertising  Sales,  or  space  area 

General  Administrative  Sales 

Distribution  Illustrated. — These  are  suggestive  rather  than 
final.  The  best  method  to  follow  must  be  determined  according 
to  circumstances.  To  illustrate  the  procedure  necessary  to  make 
the  distribution  of  such  a  general  expense  as  rent,  assume  that, 
on  the  basis  of  floor  space  occupied,  the  departments  are  charge- 
able as  follows. 

Department  A , J^ 

Department  B 3"^ 

Department  C 3^ 

Department  D }4 

and  that  the  light  bill  for  the  month  is  $50.     This  might  be 
entered  in  the  Voucher  Register  as  follows: 

Light  Expense — Clearing  Account $50 .  00 

To  Vouchers  Payable $50. 00 

When  the  distribution  is  made  to  departments  the  clearing 
account,  "Light  Expense,"  is  closed,  as  follows: 

Light  Expense — Department  A $25 .00 

Light  Expense — Department  B 12. 50 

Light  Expense — Department  C 6 .  25 

Light  Expense — Department  D 6 .  25 

To  Light  Expense — Clearing  Account $50 .  00 

1  See  Moxey,  E.  P.,  Jr.  and  others:  Practical  Accounting  Methods,  p.  195. 


DEPARTMENT  ACCOUNTING  229 

In  this  manner  all  expenses  which  it  may  be  desirable  to  charge  ' 
to  a  clearing  account  is  in  turn  charged  to  the   departmental 
accounts.     When  the  above  entries  are  posted  the  Light  Ex- 
pense— Clearing  Account  appears  as  follows: 

Light  Expense — Clearing  Account 

To  Vouchers  Payable $50.00  By  Light  Expense— Dept.  A...  .$25.00 

By  Light  Expense— Dept.  B.. .  .    12 .  50 

By  Light  Expense — Dept.  C. .  .     6.25 

By  Light  Expense— Dept.  D...     6.25 

$50.00  $50.00 


Results  Secured. — When  all  general  expenses  have  been  thus 
distributed  to  the  respective  departments  it  is  possible  to  set  up 
profit  and  loss  accounts  for  each  department.  By  combining 
them  a  profit  and  loss  account  for  the  whole  enterprise  is  also 
secured.  In  this  way  the  relative  efficiency  of  the  different  de- 
partments as  compared  with  one  another  and  with  the  whole 
establishment  may  be  learned.  Departmentalization  may  be 
carried  as  far  as  desirable;  but  ordinarily  a  practical  limit  will  be 
suggested  by  the  nature  of  the  business. 

Transfers  between  Departments. — When  transfers  of  merchan- 
dise are  made  from  one  department  to  another  these  must  be 
accounted  for  either  through  the  General  Journal  or  through  a 
special  Journal  kept  for  that  purpose.  Transfer  slips  are  made 
out  charging  the  department  receiving  the  goods  and  crediting 
the  one  surrendering  them,  at  cost  price.  At  the  end  of  the  month 
these  are  recapitulated  and  the  proper  journal  entries  formulated 
for  making  the  proper  debits  and  credits,  thus: 

Purchases — Department  A $310 .  20  ' 

To  Purcha.ses— Department  B $310.20 

To  record  transfer,  at  cost,  of  merchandise  from  De- 
partment B  to  Department  A. 

All  interdepartmental  transfers  are  similarly  recorded.  Instead 
of  crediting  the  purchases  account  of  the  department  surrendering 
the  goods,  "sales"  might  be  credited.  This  is  not  the  best 
procedure,  however,  as  no  profit  is  made  on  such  a  "sale"  because 
it  is  "at  cost."  To  credit  this  item  to  sales  account  increases 
the  total  of  sales  without  increa.sing  profits.  It  then  becomes 
necessary  to  make  deductions  from  sales  for  these  transfers  in 


230  ACCOUNTS  IN   THEORY  AND  PRACTICE 

order  to  secure  the  correct  percentage  of  profits  on  sales — an 
important  statistical  figure. 

Manufacturing. — The  same  principles  apply  to  departmental 
accounting  in  manufacturing  as  in  trading.  A  department  of  a 
factory  is  charged  with  raw  material  consumed  and  also  with  its 
proper  proportion  of  indirect  expense.  These  costs  are  charged 
to  the  departmental  goods  in  process  (or  manufacturing)  con- 
trolling account  and  at  the  same  time  are  distributed  over  the 
various  order  numbers  in  the  departmental  cost  ledger.  Sepa- 
rate finished  goods  Ledgers  may  also  be  kept  for  the  different 
departments.  Each  department  thus  becomes  a  unit,  a  fac- 
tory within  a  factory — and  its  profits  can  be  determined 
independently. 

Whether  or  not  a  factory  can  be  thus  completely  depart- 
mentalized depends  upon  the  nature  of  its  operations.  If  its 
output  is  such  that  it  requires  a  continuous  operation,  passing 
from  stage  to  stage,  and  undergoing  the  different  processes  one 
after  another,  the  factory  in  a  sense  is  but  one  large  department. 
Separate  raw  materials,  goods  in  process  and  finished  goods 
Ledgers  would  not  then  be  practicable.  But  in  so  far  as  definite 
departmental  processes  are  distinguishable  departments  may  be 
said  to  exist  and  to  serve  as  convenient  units  of  organization  for 
the  allocation  of  labor,  material  and  indirect.  In  this  case  the 
output  of  a  department  is  a  portion  of  a  process  instead  of  a 
complete  process. 


CHAPTER  XXXV 

DEPARTMENT  ACCOUNTING— PRACTICE 

Problem  1. — The  General  Retail  Company  is  engaged  in  selling 
the  following  classes  of  merchandise : 

1.  Men's  clothing 

2.  Women's  clothing 

3.  Children's  clothing 

4.  House  Furnishings 

The  store  building,  for  which  a  monthly  rental  of  $500  is 
paid,  consists  of  two  floors  and  the  basement.  The  floor  space  is 
60,000  square  feet  divided  equally  among  the  three  levels,  20,000 
square  feet  to  each.  The  basement  and  the  first  floor  are  given 
over  to  house  furnishings.  The  second  floor  is  used  as  follows: 
7,500  square  feet  for  men's  clothing;  7,500  square  feet  for 
women's  clothing;  and  5,000  square  feet  for  children's  cloth- 
ing.    All  ceilings  are  of  the  same  height. 

There  exist  separate  departments.  A,  B,  C,  and  D,  respectively, 
for  each  of  the  four  classes  of  merchandise  mentioned  above. 
The  following  departmental  accounts  are  to  be  kept : 


1.  Sales 

2.  Purchases 

3.  Returned  Sales 

4.  Returned  Purchases 

5.  Wages 

6.  General  Departmental  Expense 

7.  Selling  Expenses 

The  general  expenses  are  to 

be  charged  to  the  following  general 

clearing  accounts: 

Account 

Basis  of  Distribution 

Insurance 

Value  of  property 

Light 

Candle  power  required 

Heat 

Cubic  feet  of  space 

•Salaries — General  Officers 

Net  Sales 

Rent 

Floor  space 

Advertifing 

Net  Sales 

General  Administrative 

Net  Sales 

Bad  Debts 

Net  Sales 

231 


232  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Required : 

(a)  To  contrive  a  system  of  accounts  adequate  for  this  business. 
(6)  To  set  up  a  trial  balance  as  of  the  close  of  the  year  1919, 
inserting  assumed  amounts  for  the  various  accounts;  then 
to  set  up  departmental  income  statements,  a  general  dis- 
tribution  statement,  and  a  balance  sheet.     Assume  that 
•  the  books  were  last  closed  as  at  Dec.   31,    1918.     Also 
assume  all  data  necessary  for  transferring  to  departmental 
accounts    the    amounts    charged  to    overhead  under  the 
respective  clearing  accounts. 
Under  (o)  above  it  is  required  that  a  complete  voucher  system 
be  installed. 
Solution,  Problem  1. — The  following  books  are  necessary: 

General  Journal 

Sales  Journal 

Returned  Sales  Journal 

General  Ledger 

Accounts  Receivable  Ledger 

Cash  Journal 

Voucher  Register 

The  rulings  and  headings  of  these  books  are  shown  below: 


DEPARTMENT  ACCOUNTING— PRACTICE 


233 


1 

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At  end  of  month  debit  Accounts  Receiv- 
able for  total  sales  and  credit    the  re- 
spective  sales  accounts  in  the  General 
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At  end  of  month  credit  Accounts  Re- 
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and  debit  resFtective  sales  accounts  in 
the  General  Ledger. 

V 

234 


ACCOUNTS  IN  THEORY  AND  PRACTICE 


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DEPARTMENT  ACCOUNTING— PRACTICE 


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236  ACCOUNTS  IN  THEORY  AND  PRACTICE 


Trial  Balance,  General  Retail  Company, 
as  at  December  31,  1919 

Capital  Stock  Outstanding $  40,000 

Surplus 5,400 

Cash $  12,100 

Petty  Cash 200 

Insurance  Expired  on  Mdse-Glearing  a/c 600 

Insurance  Prepaid 240 

Light  Expense-Clearing  a/c 300 

Expense-Clearing  a/c 2,300 

Salaries  General  Officers-Clearing  a/c 11,500 

Rent  Expense-Clearing  a/c 6,000 

Advertising  Expense-Clearing  a/c 700 

General  Administrative  Expense — Clearing  a/c 2,000 

Bad  Debts  Expense-Clearing  a/c 400 

Sales:    Dept.  A '. 20,500 

Dept.  B 18,000 

Dept.  C 7,000 

Dept.  D. . , 57,000 

Purchases:  Dept.  A 17,000 

Dept.  B 14,000 

Dept.  C 4,000 

Dept.  D 35,000 

Returned  Sales:  Dept.  A 640 

Dept.  B 200 

Dept.  C 100 

Dept.  D 1,200 

Returned  Purchases:    Dept.  A 200 

Dept.  B 500 

Dept.  C 40 

Dept.  D 100 

Wages:  Dept.  A 1,500 

Dept.  B 1,200 

Dept.  C '. 500 

Dept.  D 2,000 

General  Departmental  Expense:    Dept.  A 1,400 

Dept.  B 700 

Dept.  C 300 

Dept.  D 2,000 

Selling  Expenses:  Dept.  A 800 

Dept.  B 400 

Dept.  C 100 

Dept.  D 1,000 

Accounts  Receivable 15,000 

Accounts  Payable 11,600 

Reserve  for  Bad  Debts 500 


DEPARTMENT  ACCOUNTING— PRACTICE  237 

Inventories,  Dec.  31,  1918: 

Dept.  A 4,000 

Dept.  B 3,000 

Dept.  C 1,200 

Dept.  D 17,300 

Furniture  and  Fixtures 10,000 

,  $160,880    $160,880 

Inventories,  Dec.  31,  1919: 

Dept.  A $  5,000 

Dept.  B 3,100 

Dept.  C 500 

Dept.  D 16,000 

The  following  conditions  are  determined: 

(a)  Insurance  is  distributed  on  the  basis  of  average  inventory  value, 
that  is,  old  plus  new  inventory  divided  by  2.  These  are: 

Dept.  A.  (  4,000+  5,000) -7-2=  4,500  (17.96%) 
Dept.  B.  (  3,000+  3,100)^-2=  3,050  (12.18%) 
Dept.  C.  (  1,200+  500)+2=  850(3.39%) 
Dept.  D.  (17,300  +  16,000)  H-2  =  16,650(66.47%) 

(b)  The  relative  candle  power  required  by  the  departments  for  lighting 
is  as  follows: 

Dept.  A y^    of  total 

Dept.  B %    of  total 

Dept.  C Ks  of  total 

Dept.  D %    of  total 

(c)  The  relative  heat  consumption  is  as  follows: 

Dept.  A H    of  total 

Dept.  B %    of  total 

Dept.  C K2  of  total 

Dept.  D ^^  of  total 

(d)  The  amounts  of  net  sales  are  as  follows: 

Dept.  A $19,860  (21.98%) 

Dept.  B 17,800  (19.70%) 

Dept.  C 6,900  (  7.64%) 

Dept.  D 45,800  (50.68  %) 

Salaries  of  General  Officers,  Advertising,  and  General  Ad- 
ministrative and  Bad  Debts  Expense  are  allocated  to  depart- 
ments on  the  basis  of  net  sales. 

(e)  The  amount  of  floor  space  devoted  to  the  different  departments  is  as 

follows: 

Dept.  A 7,500  sq.  ft.  (12.50%,) 

Dept.  B 7,500  sq.  ft.  (12.50  %) 

Dept.  C 5,000  sq.  ft.  (  8.33%) 

Dept.  D 40,000  sq.  ft.  (66.67  %,) 

Total 60,000  sq.  ft. 


238  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Rent  is  allocated  on  the  basis  of  floor  space  occupied. 

The  next  step  is  to  credit  the  clearing  account  and  charge 
departmental  expense  account,  the  allocation  being  determined  on 
the  bases  indicated  above.  Instead  of  opening  departmental 
expense  accounts,  however,  we  will  carry  the  distribution  direct 
to  trading  and  profit  and  loss,  as  follows: 


Trading  Account— Dept.  A.  (17.96%) $107.76 

Trading  Account— Dept.  B.  (12. 18  %) 73 .  08 

Trading  Account— Dept.  C.  (  3.39%) 20.34 

Trading  Account— Dept.  D.  (66.47  %) 398 .  82 

To  Insurance  Expired  on  Mdse. — Clearing  a/c.  $600.00 

To  carry  insurance  to  departmental  trading  accounts, 
distribution  being  on  basis  of  average  inventory  values 
in  the  departments. 

Trading  Account— Dept.  A.  H $  50.00 

Trading  Account— Dept.  B.  % 33.33 

Trading  Account— Dept.  C.  Hs 16.67 

Trading  Account— Dept.  D.  % 200.00 

To  Light  Expense— Clearing  a/c $300 .  00 

To  carry  light  expense  to  departmental  trading  ac- 
counts, distribution  being  on  basis  of  relative  candle 
power  required  by  departments. 

Trading  Account— Dept.  A.  H $    287 .  50 

Trading  Account— Dept.  B.  H 287 .  50 

Trading  Account— Dept.  C.  K2 191 .  67 

Trading  Account— Dept.  D.  %i 1,533.33 

To  Heat  Expense— Clearing  a/c $2,300 .  00 

To  carry  heat  expense  to  departmental  trading  ac- 
counts, distribution  being  on  basis  of  cubic  feet  of  space 
occupied  by  the  departments. 

Trading  Account— Dept.  A $    750.00 

Trading  Account— Dept.  B 750.00 

Trading  Account— Dept.  C. 499.80 

Trading  Account— Dept.  D 4,000.20 

To  Rent  Expense— Clearing  a/c $6,000.00 

To  carry  rent  expense  to  departmental  trading  ac- 
counts, distribution  being  on  basis  of  floor  space  de- 
voted to  departments. 

Trading  Account— Dept.  A. $153.86 

Trading  Account— Dept.  B 137.90 

Trading  Account— Dept.  C 53 .  48 

Trading  Account— Dept.  D 354.76 

To  Advertising  Expense — Clearing  a/c $700 .  00 


DEPARTMENT  ACCOUNTING— PRACTICE  239 

To  carry  advertising  expense  to  departmental  trad- 
ing accounts,  distribution  being  on  basis  of  net  sales  of 
the  departments. 

Administrative  Account — Dept.  A $2,527.70 

Administrative  Account — Dept.  B 2,265. 50 

Administrative  Account — Dept.  C 878. 60 

Administrative  Account — Dept.  D 5,828.20 

To  Salaries  General  Officers— Clearing  a/c $11,500.00 

To  carry  salaries  of  general  officers  to  departmental 
administration  accounts,  distribution  being  on  basis  of 
net  sales  of  the  departments. 

Administrative  Account — Dept.  A S    439.60 

Administrative  Account — Dept.  B 394.00 

Administrative  Account — Dept  .C 152.80 

Administrative  Account — Dept.  D 1,013.60 

To  General  Administrative  Expense — Clearing 

a/c $2,000.00 

To  carry  general  administrative  expense  to  depart- 
mental administration  accounts,  distribution  being  on 
basis  of  net  sales  of  the  departments. 

Administrative  Account — Dept.  A $  87.92 

Administrative  Account — Dept.  E 78.80 

Administrative  Account — Dept.  C 30.56 

Administrative  Account — Dept.  D 202.72 

To  Bad  Debts— Clearing  a/c $400 .  00 

To  carry  bad  debts  expense  to  departmental  admin- 
istration accounts,  distribution  being  on  basis  of  net 
sales  of  the  departments. 

This  closes  all  clearing  accounts  into  the  departmental  trading 
and  administrative  accounts.  Next  the  closing  entries  must  be 
made  for  the  departmental  accounts.     These  follow: 

Trading  Account,  Dept.  A $  4,000.00 

Trading  Account,  Dept.  B 3,000.00 

Trading  Account,  Dept.  C 1,200.00 

Trading  Account,  Dept.  D 17,300.00 

To  Dept.  A.  Inventory $  4,000.00 

Dept.  B.  Inventory 3,000.00 

Dept.  C.  Inventory 1,200.00 

Dept.  D.  Inventory 17,300.00 

To  carry  inventory  (old)  to  trading   accounts  of 
departments.' 

'  Note  that  inventories,  purchases,  sales,  etc.,  are  carried  direct  to  the 
trading  accounts.  They  are  sometimes  taken  to  a  merchandise  account, 
but  it  is  thought  that  the  above  procedure  will  here  facilitate  the  construc- 
tion and  understanding  of  the  trading  and  profit  and  loss  statement. 


240  ACCOUNTS  IN   THEORY  AND  PRACTICE 

Dept.  A.  Inventory $  5,000.00 

Dept.  B.  Inventory 3,100.00 

Dept.  C.  Inventory 500.00 

Dept.  D.  Inventory 16,000.00 

To  Trading  Account  Dept.  A $  5,000.00 

Trading  Account  Dept.  B 3,100.00 

Trading  Account  Dept.  C 500.00 

Trading  Account  Dept.  D 16,000.00 

To  credit  new  inventories  to  trading  accounts  of  the 
departments  and  charge  the  proper  inventory  ac- 
counts. 

Sales— Dept.  A $20,500.00 

Sales— Dept.  B 18,000.00 

Sales— Dept.  C 7,000.00 

Sales— Dept.  D 57,000.00 

To  Trading  Account— Dept.  A $20,500.00 

Trading  Account— Dept.  B 18,000.00 

Trading  Account— Dept.  C 7,000.00 

Trading  Account— Dept.  D 57,000.00 

To  carry  sales  to  the  trading  accounts  of  the  de- 
partments, closing  the  department  sales  accounts. 

Trading  Account— Dept.  A $17,000.00 

Trading  Account— Dept.  B 14,000.00 

Trading  Account— Dept.  C 4,000.00 

Trading  Account— Dept.  D 35,000.00 

To  Purchases— Dept.  A $17,000.00 

Purchases— Dept.  B 14,000 .  00 

Purchases— Dept.  C 4,000 .  00 

Purchases— Dept.  D 35,000.00 

To  carry  purchases  to  the  trading  accounts  of  the 
departments  and  to  close  the  departmental  purchases 
account. 

Trading  Account— Dept.  A $    640.00 

Trading  Account— Dept.  B 200.00 

Trading  Account— Dept.  C 100.00 

Trading  Account— Dept.  D 1,200.00 

To  Returned  Sales— Dept.  A $    640.00 

Returned  Sales— Dept.  B -  200.00 

Returned  Sales— Dept.  C 100.00 

Returned  Sales— Dept.  D 1,200.00 

To  carry  returned  sales  to  trading  accounts  of  the 
departments  and  to  close  the  returned  sales  account. 

Returned  Purchases— Dept.  A $200.00 

Returned  Purchases— Dept.  B 500.00 

Returned  Purchases — Dept.  C 40.00 

Returned  Purchases— Dept.  D 100.00 


DEPARTMENT  ACCOUNTING— PRACTICE  241 

To  Trading  Account— Dept.  A $200 .  00 

.     Trading  Account— Dept.  B 500 .  00 

Trading  Account— Dept.  C 40.00 

Trading  Account— Dept.  D 100.00 

To  carry  returned  purchases  to  trading  accounts  of 
the  departments  and  to  close  the  returned  purchases 
accounts. 

Trading  Account— Dept.  A $1,500.00 

Trading  Account— Dept.  B 1,200.00 

Trading  Account— Dept.  C 500.00 

Trading  Account— Dept.  D 2,000.00 

To  Wages— Dept.  A $1,500.00 

Wages— Dept.  B 1,200.00 

Wages— Dept.  C 500.00 

Wages— Dept.  D 2,000.00 

To  carry  wages  to  department  trading  accounts 
and  to  close  the  wages  accounts. 

Trading  Account— Dept.  A $1,400.00 

Trading  Account— Dept.  B , 700.00 

Trading  Account— Dept.  C 300.00 

Trading  Account— Dept.  D 2,000.00 

To  General  Dept.  Exp.— Dept.  A $1,400.00 

General  Dept.  Exp.— Dept.  B 700. 00 

General  Dept.  Exp.— Dept.  C 300.00 

General  Dept.  Exp.— Dept.  D 2,000 .  00 

To  carry  general  dept.  expense  to  dept.  trading 
accounts  and  to  close  the  general  dept.  expense  ac- 
counts. 

Trading  Account— Dept.  A $    800.00 

Trading  Account— Dept.  B 400.00 

Trading  Account— Dept.  C 100.00 

Trading  Account— Dept.  D 1,000.00 

To  Selling  Expense— Dept.  A $    800 .  00 

Selling  Expense— Dept.  B 400.00 

Selling  Expense— Dept.  C 100.00 

Selling  Expense— Dept.  D 1,000.00 

To  carry  selling  expense  to  the  departmental  trad- 
ing accounts  and  to  close  the  selling  expense  accounts. 

The  income  statements  of  the  departments  follows: 


16 


242  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Income  Statement,  Department  A,  for  year  ending  Dec.  31,  1919: 

Trading  Section 

Inventory,  Dec.  31.  1918 S  4.000.00  Sales $20,500.00 

Purchases 17,000.00  Less   Returned 

Sales 640.00 


$21,000.00  Net  Sales $19,860.00 

Leas    Inventory,      Dec.      31, 

1919 .5.000.00  Bftl  ance,  Gross 

Tra  Jing  Loss. ...                                989 .  12 

$16,000.00 
Less  Returned  Purchases 200. 00 


Coat  of  goods  sold  (turnover)  $15,800.00 

Wages 1,500. 00 

General   Departmental    Ex- 
pense   1.400.00 

Selling  Expense 80'J.OO 

Insurance  on  Mdse 107 .  78 

Light  Expense 50 .  00 

Heat  Expense 287.50 

Rent  Expense 750. 00 

Advertising  Expense 153.86 


$20,849.12  $20,849.12 


Administration  Section 

Balance,  Gross  Trading  Loss.  .  $    989.12               Balance.  Net  Loss,  carried  to 

Salaries,  General  Officers 2,527.70  Distribution  Section $4,044.34 

General     Administrative     Ex- 
pense   439.60 

Bad  Debts  87.92 

$4,044.34  $4,044.34 


DEPARTMENT  ACCOUNTING— PRACTICE  243 


Income  Statement,  Department  B,  for  year  ending 
Dec.  31,  1919 

Trading  Section 

Inventory,  Dec.  31,  1918.$  3,000.00       Sales $18,000.00 

Purchases 14,000.00       Less  Returned  Sales ..  .         200.00 

17,000.00       Net  Sales. $17,800.00 

Less   Inventory   Dec.    31, 

'19 3,100.00 

13,900.00 
Less    Returned    Pur- 
chases        500.00 

Cost  of  goods  sold  (turn- 
over)   $13,400.00 

Wages 1,200.00 

General  Departmental  Ex- 
pense   700.00 

Selling  Expense 400 .  00 

Insurance  on  Mdse 73.08 

Light  Expense 33 .  33 

Heat  Expense 287 .  50 

Rent  Expense 750 .  00 

Advertising  Expense 137.90 

Balance,    Gross     Trading 

Profit 818.19 

$17,800.00  $17,800  00 


Administration  Section 

Salaries,  General  OfficerB.$2,265.  .50     Balance,   Gross   Trading 

Profit $818.19 

General       Administrative  Balance,  Net  Loss,  carried 

Expense 394.00        to  Distribution  Section.    1,920. 11 

Bad  Debts 78.80 

$2,738.30  $2,738.30 


244  ACCOUNTS  IN  THEORY  AND  PRACTICE 


Income  Statement,  Department  C,  for  year  ending 
Dec.  31,  1919 : 

Trading  Section 
Inventory    Dec.    31, 

1918 $1,200.00     Sales $7,000.00 

Purchases 4,000.00    Less  Returned  Sales.     100.00 

$5,200 .  00     Net  Sales $6,900 .  00 

Less   Inventory   Dec. 
31,1919 500  00 

$4,700.00 
Less    Returned    Pur- 
chases          40 . 00 

Cost   of   Goods   sold 

(turnover) $4,660.00 

Wages 500.00 

General  Departmen- 
tal Expense 300 .  00 

Selling  Expense 100.00 

Insurance  on  Mdse 20 .  34 

Light  Expense 16. 67 

Heat  Expense 191 .  67 

Rent  Expense 499.80 

Advertising  Expense 53.48 

Balance,  Gross  Trad- 
ing Profit 558.04 

$6,900.00  $6,900.00 

Administration  Section 

Salaries,  General  Officers    $878.60         Balance,   Gross   Trading 

ing  Profit $  558.04 

General     Administrative  Balance,   Net  Loss,  car- 
Expense 152. 80  ried     to     Distribution 

Bad  Debts 30.66  Section 503.92 

$1,061.96  $1,061.96 


DEPARTMENT  ACCOUNTING— PRACTICE  245 


Income  Statement,  Department  D,  for  year  ending 
Dec.  31,  1919: 


Inventory,      Dec. 

31,  1918 

Purchases 


Less     Inventory 
Dec.  31,  1919.. 


Less  Returned 
Purchases 

Cost  of  Goods  sold 
(turnover) 

Wages 

General  Depart- 
mental Expense. 

Selling  Expense.. . . 

Insurance  Mdse.  . . 

Light  Expense 

Heat  Expense 

Rent  Expense 

Advertising  Ex- 
pense  

Balance,  Gross 
Trading  Profit. . . 


Trading  Section 


35,000.00 

Less  Returned. 
Sales 

Net  Sales 

1,200.00 

52,300.00 

$55,800.00 

15,000.00 

36,300.00 

100  00 

$36,200.00 
2,000.00 

2,000.00 
1,000.00 
398.82 
200.00 
1,533.33 
4,000.20 

354.76 

8,112.89 

$55,800.00 

$55,800.00 

Administration  Section 

Salaries,  General  Officers.. ..$5828. 20     Balance,    Gross    Trading 

Profit $8,112.89 

General       Administrative 

Expense 1,013.60 

Bad  Debts 202.72 

Balance,  Net  Profit,  car- 
ried to  Distribution  Sec- 
tion     1,068.37 

$8,112.89  $8,112.89 


246  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Distribution  Section  (all  Dep'ts.) 

Net  Loss,  Men's $4,044 .  34  Net  Profit,  House  Fur- 
nishings  $1,068.37 

Net  Loss,  Women's 1,920. 11     Balance,     Net     Ixiss     all 

Depts.,  carried  to  Sur- 

Net  Loss,  Children's 503.92        plus 5,400.00 

$6,468.37  $6,468.37 


Balance  Sheet,  General  Retail  Company,  as  at 
'December  31,  1919: 

Assets  Liabilities  and  Capital 
Cash $12,100.00  Capital  Stock  Outstand- 
ing  $40,000.00 

Petty  Cash 200.00    Accounts  Payable 11,640.00 

Insurance  Prepaid 240.00  Reserve  for  Bad  Debts.  .         500.00 

Accounts  Receivable.  .. .     15,000.00 
Inventories,      Dec.     31, 

1919 24,000.00 

$52,140.00  $52,140.00 


CHAPTER  XXXVI 

DEPARTMENT  ACCOUNTING— PRACTICE   (Continued) 

Problem  2. — The  Ashton-Noble  Company  began  business  on 
January  1,  1918.  The  company  operates  a  department  store 
consisting  of  five  departments,  as  follows: 

Dept.  A.— Toys 

Dept.  B. — Groceries 

Dept.  C. — House  Furnishings 

Dept.  D. — Clothing,  Women's  and  Children's 

Dept.  E. — Shoes 

The  store  building,  which  is  owned  by  the  Ashton-Noble  Com- 
pany, consists  of  three  floors  and  a  basement.  The  total  floor 
space  is  80,000  square  feet  divided  equally  among  the  four  levels. 
The  basement  is  occupied  by  Dept§.  A  and  B,  the  former  occupy- 
ing 8,000  square  feet  of  floor  space  and  the  latter  12,000  square 
feet.  The  entire  first  floor  is  occupied  by  Dept.  C,  except  2,000 
square  feet  which  is  rented  to  a  fruit  dealer  at  a  monthly  rental 
of  $150.  Dept.  D  occupies  the  entire  second  floor  and  Dept. 
E  the  entire  third  floor.  The  basement  ceiHng  is  8  feet  above  the 
floor;  all  other  ceilings  are  9  feet  high. 

The  following  departmental  accounts  are  kept: 

1.  Sales 

2.  Purchases 

3.  Returned  Sales 

4.  Returned  Purchases 

5.  Wages 

7.  Advertising 

8.  Miscellaneous  Selling  Expense. 

General  expenses  are  to  be  charged  to  the  following  general 
clearing  accounts  and  distributed  on  the  basis  indicated : 

247 


248  ACCOUNTS  IN   THEORY  AND  PRACTICE 

Account  Basis  of  Distribution 

Insurance — Building  Floor  space 

Insurance — Mdse.  Value  of  property 

Repairs  on  Building.  Floor  space 

Depreciation  of  Building  Floor  space 

Taxes  on  Building  Floor  space 

Light  Candle  Power  Required 

Heat  Cubic  Feet  of  Space 

Salaries  General  Officers  Net  Sales 

General  Administrative  Net  Sales 

Bad  Debts  Net  Sales 


Following  is  the  trial  balance  of  the  Ashton-Noble  Company  as 
at  Dec.  31,  1919  (student  will  insert  amounts  in  the  two  vacant 
places) : 


Capital  Stock  Outstanding $  30,000 .  00 

Cash 

Surplus 8,700.00 

Petty  Cash $     300.00 

Insurance  Expired  in  mdsc-clearing  a/c 780.00 

Insurance  Prepaid  on  mdse 500 .  00 

Insurance  Expired  on  Building-clearing  a/c. . . .  1,100.00 

Insurance  Prepaid  on  Building 1,740. 00 

Repairs  on  Building-clearing  a/c 540 .  00 

Depreciation  of  Building — clearing  a/c 500.00 

Reserve  for  Depreciation  of  Building 500.00 

Taxes  on  Building 1,000.00 

Building 24,000.00 

Light  Expense — clearing  a/c 400.00 

Heat  Expense — clearing  a/c 

Salaries  General  Officers — clearing  a/c 8,000 .  00 

General  Administrative  Expense — clearing  a/c.  1,200.00 

Bad  Debts  Expense — clearing  a/c 300 .  00 

Reserve  for  Bad  Debts 300 .  00 

Space  Rented 1,800.00 

Sales:  Dept.  A 5,000.00 

Dept.  B 23,000.00 

Dept.  C 49,000.00 

Dept.  D ; 45,000.00 

Dept.  E 41,000.00 

Purchases:  Dept.  A 3,000.00 

Dept.  B 17,000.00 

Dept.  C 35,000.00 

Dept.  D 36,000.00 

Dept.  E 34,000.00 


DEPARTMENT  ACCOUNTING— PRACTICE  249 

Returned  Sales:  Dept.  A 40.00 

Dept.  B 350.00 

Dept.  C 890.00 

Dept.  D 500.00 

Dept.  E 200.00 

Returned  Purchases:    Dept.  A 500. 00 

Dept.  B 1,100.00 

Dept.  G 600.00 

Dept.  D 2,000.00 

Dept.  E 700.00 

Wages:  Dept.  A 720.00 

Dept.  B 1,600.00 

Dept.  C 2,400.00 

Dept.  D 2,400.00 

Dept.  E 2,000.00 

General  Departmental  Expense:    Dept.  A 300.00 

Dept.  B 500.00 

Dept.  C 800.00 

Dept.  D 700.00 

Dept.  E 650.00 

Advertising:  Dept.  A 100.00 

Dept.  B 300.00 

Dept.  C 1,200.00 

Dept.  D 800 .  00 

Dept.  E 300.00 

Miscellaneous  Selling  Expenses:  Dept.  A 127.00 

Dept.  B 302.00 

Dept.  C 808.00 

Dept.  D 700.00 

Dept.  E 560.00 

Accounts  Receivable 17,000 . 00 

Accounts  Payable 9,000 .  00 

Furniture  and  Fixtures 13,000 .  00 


$218,200.00    $218,200.00 

The  amounts  inserted  in  the  blank  spaces  for  Cash  and 
Heat  Expense — Clearing  a/c  must  be  such  that  their  total  is 
$3,593.  It  is  suggested  that  Cash  be  placed  between  $500 
and  $1,000  and  the  balance  placed  in  Heat  Expense — Clearing 
a/c. 

Note  that  the  adjustment  for  depreciation  for  the  year  has 
been  made. 

The  following  additional  data  is  given  to  aid  in  determining 
the  proper  distribution  of  amounts  charged  to  clearing  account. 

In  determining  distribution  of  insurance  on  merchandise  use 
inventory  values  as  at  Dec.  31,  1919. 


^50  ACCOUNTS  IN  THEORY  AND  PRACTICE 

The  ratios  of  candle  power  required  are  as  follows: 

Dcpt.  A.  8 
Dept.  B.  12 
Dept.  C.  12 
Dept.  D.  15 
Dept.  E.  15 
Space  Rented  3 

A  proper  portion  of  insurance  on  building,  repairs  on  building, 
depreciation  of  building,  taxes  on  building,  light  and  heat  should 
be  charged  to  the  account  "Space  Rented,"  so  that  the  balance 
of  this  account  will  show  net  profit  or  loss  from  this  source. 
This  balance  will  be  carried  direct  to  the  distribution  section. 

Required : 

(a)  To  contrive  a  system  of  accounts  adequate  to  take  care  o£ 
this  business. 

(6)  To  set  up  departmental  income  statements,  a  general 
distribution  statement,  and  a  balance  sheet. 

Under  (a)  above  it  is  required  that  the  books  be  such  as  are 
necessary  for  a  voucher  system. 


CHAPTER  XXXVII 
MANUFACTURING  ACCOUNTING 

General  Principles. — Manufacturing  accounting  consists  in 
the  adaptation  of  the  principles  of  double  entry  to  the  processes 
of  production.  In  Chapter  XVI  the  methods  of  expanding  and 
specializing  accounting  records  were  discussed  and  illustrated. 
The  work  of  creating  specialized  records  consists  in  applying 
accounting  principles  to  given  conditions.  In  so  far  as  account- 
ing principles  are  concerned  cost  accounting  does  not  differ  from 
mercantile  accounting.  It  consists  in  their  application  to  differ- 
ent conditions.  Were  the  general  principles  any  different  from 
those  that  govern  other  accounting,  cost  keeping  would  be  a 
distinct  science  instead  of  a  branch  of  accounting. 

Meaning  of  "Cost." — Fundamentally,  all  accounting  is  based 
on  costs.  But  when,  as  is  the  case  with  trading  concerns,  cost 
means  simply  the  purchase  price  of  a  commodity,  the  matter  is 
so  elementary  that  the  importance  of  this  "cost"  is  not  strongly 
impressed  upon  our  minds.  Yet  this  is  the  germ  of  cost  account- 
ing. The  simplest  cost  system  is  fully  outlined  in  the  following 
journal  entry: 

Purchases $100.00 

To  Cash • , $100.00 

To  record  "cost"  of  goods  bought. 

When  commodities  are  purchased  in  the  same  form  in  which  they 
are  ultimately  sold,  the  determination  of  their  cost  is  a  simple 
task.  It  consists  of  the  invoice  price  of  the  goods  purchased 
less  any  discounts  secured  through  prompt  payment,  plus  the 
cost  of  placing  them  "on  the  shelves"  ready  for  sale.  The 
Purchases  Journal  or  Voucher  Register  shows  the  bare  cost  of 
the  goods  while  the  additional  information  required  is  found  in 
the  general  ledger  accounts. 

When,  however,  commodities  are  not  sold  in  the  same  form  in 
which  they  are  purchased  the  situation  is  more  complicated. 
The  Purchases  Journal  and  Cash  Journal  no  longer  constitute  a 
complete  cost  system.     They  merely  show  the  cost  of  commodi- 

251 


252  ACCOUNTS  IN   THEORY  AND  PRACTICE 

ties  "as  purchased."  It  is  also  necessary  to  show  the  cost  of 
commodities  "as  sold."  When  commodities  are  purchased,  not 
to  be  sold  in  the  same  form,  but  for  the  purpose  of  rearranging 
or  altering  them  and  thus  fashioning  them  into  other  commodities 
differing  more  or  less  widely  in  appearance,  value,  and  usefulness 
from  the  original  commodities,  they  are  said  to  undergo  a  process 
of  manufacture.  When  products  are  manufactured  into  other 
products  they  incur  increments  of  cost — the  cost  of  manufacture. 
Evidently,  then,  for  one  engaged  in  manufacturing  the  cost  of 
the  commodities  which  he  sells  is  not  the  cost  of  the  commodities 
which  he  purchases  nor  the  cost  of  the  process  of  manufacture, 
but  a  combination  of  the  two.  Every  manufactured  article 
costs : 

1.  Raw  Material  '  -inner 


2.  Expense  of  Manufacture 

"Raw  Materials"  is  a  phrase  of  relative  significance.  It  is 
that  with  which  a  given  process  of  manufacture  begins.  What  is 
raw  material  to  one  process  is  finished  product  to  another.  A 
bit  of  material  may  be  successively  raw  material  and  finished 
product  several  times  before  it  arrives  at  the  ultimate  form  of  a 
consumable  commodity.  An  illustration  is  afforded  by  paint, 
screws,  and  the  various  materials  entering  into  the  construction 
of  furniture.  Paint  is  the  finished  product  of  the  paint  manu- 
facturer as  are  screws  of  the  hardware  manufacture,  but  to  the 
furniture  manufacturer  they  serve  as  raw  materials. 

Analysis  of  Cost. — The  analysis  of  cost  of  a  manufactured 
commodity  may  be  carried  still  further.  Cost  of  manufacture 
is  like  a  chemical  compound  which  can  be  broken  up  into  its 
elements.  One  of  these  elements  is  labor,  while  the  remaining 
ones  consist  of  various  expenses  which  are  customarily  considered 
in  toto  as  burden  or  overhead.  Revising  our  outline  of  the  cost 
of  a  manufactured  article  we  have,  then : 

1.  Raw  Materials 

2.  Expense  of  Manufacture 

a.  Labor 

b.  Indirect 

By  labor  cost  is  meant  the  cost  of  wages  paid  to  workmen  for 
time  spent  on  a  given  commodity.  If  a  workman  receives  50 
cents  an  hour  and  spends  three  hours  of  his  time  on  an  article 


MANUFACTURING  ACCOUNTING  253 

being  manufactured,  the  labor  cost  applicable  to  that  article, 
for  this  workman,  is  $1.50.  By  keeping  a  record  of  all  labor 
spent  on  a  commodity  the  total  labor  cost  is  secured. 

Indirect  costs,  sometimes  called  burden,  are  less  easily  ac- 
counted for  and  give  rise  to  the  most  difficult  cost  problem. 
They  include  those  costs  that  are  not  directly  apphcable  to  any 
given  process,  but  which  are  incidental  to  and  a  part  of,  general 
operations;  and  without  which  the  work  of  manufacturing  could 
not  be  executed.  Among  the  indirect  costs  are  insurance,  power, 
taxes,  salaries  of  foremen  and  superintendents,  certain  kinds  of 
labor  that  cannot  be  directly  apphed,  such  as  janitor  service  and 
repair  work,  and  so  on.  These  expenses  occur  perpetually,  but  they 
are  for  the  benefit  of  the  whole  factory  or  a  department  thereof, 
rather  than  for  that  of  any  particular  process.  Nevertheless 
each  commodity  manufactured  must  be  charged  with  its  due 
proportion  of  these  indirect  costs.  The  proper  basis  for  making 
such  a  distribution  of  indirect  over  manufactured  commodities 
will  be  considered  later  in  this  chapter. 

Trading  vs.  Manufacturing  Accounts. — The  chief  difference 
between  the  accounting  system  of  a  trading  concern  and  of  an 
enterprise  engaged  in  manufacturing  consists  of  an  extension  of 
journals  and  ledgers  in  case  of  the  manufacturing  enterprise  to 
supply  an  adequate  record  for  its  additional  activities.  These 
additional  activities  consist  of  the  purchase  and  handUng  of  the 
raw  materials,  the  process  of  manufacture,  and  the  transfer  of 
manufactured  articles  from  the  factory  to  a  finished  goods 
department.  From  this  point  on  the  work  differs  in  no  way 
from  that  of  a  mercantile  concern,  because  finished  goods  cor- 
respond to  the  merchandise  inventory  of  a  trading  enterprise. 
The  additional  work  performed  by  the  manufacturer  requires 
the  installation  of  such  records  as  will  furnish  all  necessary  in- 
formation regarding,  (a)  the  kind,  quantity,  and  cost  of  raw 
materials  on  hand,  (6)  the  transfer  of  this  raw  material  into  the 
factory,  (c)  the  increments  of  cost  to  the  article  being  manu- 
factured, from  raw  materials,  labor,  and  indirect,  (rf)  the  transfer 
of  the  completed  article  from  the  factory  to  the  finished  goods 
department. 

Purchase  of  Raw  Materials. — Raw  materials  are  ordered  by  a 
purchasing  agent  upon  requisition  from  the  foreman  of  the 
factory,  or  department  thereof.  The  order  may  be  made  out 
in  triplicate,  one  copy  being  sent  to  the  party  which  is  to  furnish 


254  ACCOUNTS  IN  THEORY  AND  PRACTICE 

the  raw  materials,  one  to  the  receiving  department,  and  one  to 
the  accounting  department.  If  the  purchasing  agent  also  desires 
a  copy  of  the  order  it  should  be  made  out  in  quadruplicate.  When 
the  invoice  for  the  goods  is  received  it  is  compared  with  the  pur- 
chase order  and  then  sent  to  the  receiving  department  to  be 
checked  up  with  the  goods  when  they  arrive.  If  the  goods  are 
as  ordered  the  invoice  serves  next  as  authority  for  an  entry  in  the 
Purchases  Journal  or  Voucher  Register.  The  form  of  either  the 
Purchases  Journal  or  Voucher  Register  will  vary  with  conditions. 
Columns  should  be  provided  for  the  different  departments.  In 
its  simplest  form  the  Purchases  Journal  would  appear  as  an 
ordinary  journal  with  a  column  for  the  details  as  to  character 
and  quantity  of  raw  materials  purchased  and  one  for  the  amount 
of  the  purchase. 

If  a  Purchases  Journal  is  kept  postings  are  made  to  two  sub- 
ordinate ledgers,  namely,  the  Accounts  Payable^  Ledger,  in  which 
accounts  are  kept  with  creditors  the  same  as  in  an  ordinary 
mercantile  business,  and  the  Raw  Materials  Ledger,  in  which 
accounts  are  kept  with  the  various  classes  of  raw  materials  used. 
If  materials  are  purchased  on  a  departmental  basis,  the  Raw 
Materials  Ledger  may  be  divided  into  sections  corresponding  to 
departments,  or  separate  Raw  Materials  Ledgers  may  be  pro- 
vided. Similarly  separate  Purchases  Journals  may  be  provided, 
if  desirable.  If  the  Voucher  Register  is  used  no  subordinate 
Accounts  Payable  Ledger  is  required. 

In  the  Raw  Materials  Ledger  accounts  are  kept  with  each  class 
of  raw  material  and  spaces  are  provided  to  show  maximum  and 
minimum  quantities,  the  amounts  received,  the  amounts  sent 
into  factory  on  requisition,  etc.  At  the  close  of  each  month  the 
total  of  purchases  as  shown  by  the  Purchases  Journal  or  Voucher 
Register  is  posted  to  the  debit  of  the  raw  materials  controlling 
account  and  to  the  credit  either  of  the  accounts  payable  or  of  the 
vouchers  payable  controlling  account  in  the  General  Ledger. 

Origin  of  Manufacturing  Order. — The  manner  in  which  an 
order  for  the  manufacture  of  a  commodity  originates  varies  with 
circumstances.  Sometimes  goods  are  manufactured  for  stock, 
that  is,  they  are  manufactured  before  a  purchaser  is  secured  for 
them.  Sometimes  they  are  manufactured  to  order  only.  Natu- 
rally the  plan  to  be  followed  will  depend  upon  the  character  of  the 
output.  If  it  is  of  a  kind  which  meets  with  a  continuous,  wide, 
and  steady  demand,  then  manufacture  for  stock  is  possible  since 


MANUFACTURING  ACCOUNTING  255 

it  is  not  difficult  to  find  a  market.  On  the  other  hand,  there  may 
be  such  an  exceedingly  narrow  market  for  certain  classes  of 
commodities  that  they  are  manufactured  only  to  order. 

The  Order  Number. — Whatever  the  motive  leading  to  the 
decision  to  manufacture  a  commodity,  the  actual  work  is  started 
by  a  responsible  official  who  gives  the  order  for  the  execution  of 
a  given  piece  of  work.  The  order  is  given  a  number  by  which  it  is 
known  from  start  to  completion  of  the  manufacturing  process. 
Thus  Order  No.  420  will  always  refer  to  a  given  line  of  work  in 
process  of  manufacture,  and  which  was  so  designated  before  the 
work  began  on  it.  Such  an  order  number  may  refer  either  to  a 
single  commodity,  as  a  machine,  or  to  a  large  number  of  like 
articles  made  up  under  a  single  order,  as  a  gross  of  overalls  or  one 
thousand  steel  wrenches.  Before  work  is  begun  on  machinery, 
etc.,  the  specifications  must  be  made  in  the  drafting  department. 

Production  or  Plant  Orders. — Sometimes  work  is  done  by  way 
of  an  addition  or  a  repair  to  plant.  Orders  for  such  work  should 
be  distinguished  from  orders  manufactured  for  trade.  This  is 
accomplished  by  classifying  all  orders  into  production,  plant,  and 
repair,  and  prefixing  the  proper  explanatory  word  to  the  number 
of  the  order.  Thus  "Production  Order  No.  450"  refers  to  an 
order  for  stock  or  trade  while  "Plant  Order  No.  475"  refers  to 
an  order  to  be  executed  for  the  purpose  of  making  some  addition 
to  plant. 

Requisition  of  Materials. — As  soon  as  the  foreman  of  the 
factory,  or  of  the  department  in  which  the  work  is  to  be  executed 
or  begun,  receives  the  order  from  headquarters  to  manufacture  a 
given  commodity,  he  issues  stores  requisitions  upon  the  keeper  of 
the  raw  materials  for  the  necessary  materials  with  which  to 
begin  work.  All  of  the  stores  requisitions  are  numbered  to 
correspond  to  the  order  number  of  the  job  to  which  they  refer. 
The  stores  requisition  may  itself  be  used  as  a  posting  medium 
direct  to  the  proper  ledgers,  or  from  it  entry  may  be  made  in  a 
"Materials  to  Factory  Journal."  Whichever  method  is  followed, 
the  principle  is  the  same. 

Accounting  Procedure,  Labor,  Materials,  Indirect. — From  the 
Materials  to  Factory  Journal  postings  are  made  to  the  credit 
side  of  the  various  raw  materials  accounts  in  the  Raw  Materials 
Ledger  and  to  the  debit  of  the  proper  order  number  account  in 
the  Cost  Ledger.  The  order  number  accounts  in  the  Cost  Ledger 
are  charged  with  the  various  elements  of  cost — raw  materials, 


256  ACCOUNTS  IN  THEORY  AND  PRACTICE 

labor,  and  indirect — as  they  accrue  or  as  soon  thereafter  as  is 
practicable.  The  total  amount  of  the  raw  materials  sent  into 
factory  on  such  requisitions  is  shown  by  the  total  of  the  Materials 
to  Factory  Journal.  At  the  end  of  each  month  this  total  is 
posted  to  the  credit  side  of  the  raw  materials  controlling  account 
and  to  the  debit  side  of  the  manufacturing  account  (controlling 
the  Cost  Ledger)  in  the  General  Ledger. 

As  raw  materials  are  but  one  of  the  three  elements  of  cost,  it  is 
necessary  to  make  provision  for  the  charging  of  the  various  order 
numbers  with  their  direct  labor  cost  and  proper  proportion  of 
indirect.  An  acciu-ate  record  of  the  time  spent  by  workmen  on 
orders  is  required.  For  this  purpose  each  workman  is  provided 
with  a  time  card  on  which  he  enters  the  time  spent  on  one  or 
more  orders.^  The  workman's  name  and  number  are  entered 
upon  the  card,  also  his  wage  rate.  Space  is  provided  for  such  a 
description  of  the  work  performed  as  will  facilitate  making  the 
charge  to  the  proper  order  number. 

These  time  reports,  when  collected  and  assorted  according  to 
order  numbers,  furnish  data  for  all  charges  to  the  various  order 
numbers  on  account  of  productive  labor.  When  assorted  accord- 
ing to  workmen  they  afford  a  check  upon  the  payroll. 

At  the  end  of  the  month  when  the  total  of  productive  labor  is 
thus  ascertained  the  following  entry  is  made  in  the  General  Journal : 

Manufacturing 

To  Payroll 

or  if  the  voucher  system  is  used: 

Manufacturing 

To  Payroll  Vouchers  Payable 

The  total  of  productive  labor  thus  charged  to  manufacturing 
account  is  also  distributed  over  the  various  order  number 
accounts  in  the  Manufacturing  or  Cost  Ledger,  which  is  con- 
trolled by  the  manufacturing  account  in  the  General  Ledger. 
The  proper  distribution  of  the  labor  cost  over  the  order  numbers 
is  obtained  from  the  time  reports  referred  to  above. 

^  The  student  is  referred  to  a  series  of  articles  by  E.  S.  Clark,  in  the  Dec, 
1916,  and  following  nuvaheraoi  Industrial  Management,  on  "Fractical  Costs." 
In  the  March,  1917,  number,  page  768,  are  found  forms  illustrating  the  work- 
man's time  report,  the  material  requi^ition,  the  production  order,  and  the 
manufacturing  cost  sheet  or  cost  ledger.  This  series  discusses  in  detail  the 
method  of  distributing  indirect. 


MANUFACTURING  ACCOUNTING  257 

Proration  of  Indirect  Costs. — Finally,  the  indirect  costs  must 
be  prorated  over  the  different  accounts  in  the  Cost  Ledger  on  an 
approximately  accurate  basis.  This  distribution  of  the  indirect 
costs  is  the  most  difficult  problem  of  manufacturing  accounting. 
Before  considering  the  various  methods  of  distributing  indirect 
costs,  let  us  secure  a  better  understanding  of  what  the  component 
parts  of  indirect  are. 

Sources  of  Indirect  Costs. — The  amount  and  character  of 
indirect  are  dependent  upon  the  nature  of  the  plant  in  which 
they  occur.  In  a  broad  sense  it  may  be  said  that  they  arise 
out  of  (a)  expenses  incident  to  the  upkeep  and  use  of  buildings 
and  (6)  expenses  of  power  production.'  Incident  to  the  upkeep 
and  use  of  buildings  are  taxes,  insurance,  depreciation,  repairs, 
heating,  lighting,  and  janitor  and  watchman's  service.  In  case 
of  rented  buildings  the  rent  charge  takes  the  place  of  all  or  a  part 
of  the  above.  The  amount  of  each  of  the  above  items  is  deter- 
mined on  some  practical  basis — taxes  by  the  state,  insurance  by 
the  management,  depreciation  by  the  character  of  the  buildings, 
repairs,  heating,  lighting  and  janitor's  and  watchman's  services 
by  actual  requirements. 

Incident  to  power  production  are  insurance  on  boilers,  pipes, 
etc.,  depreciation,  fuel,  supplies,  maintenance,  wages  of  engineers, 
firemen,  etc.,  power  purchased  (if  any),  and  such  proportion  of 
building  expense,  mentioned  above,  as  is  applicable  to  power 
production.  This  last  would  therefore  represent  a  credit  to 
building  expense  and  a  debit  to  power  production  expense. 

General  and  Administrative  Expenses. — Not  all  expenses 
other  than  labor  and  materials  should  be  considered  as  indirect 
to  be  distributed  or  prorated  over  the  various  jobs  numbers. 
There  are  certain  kinds  of  expense  that  are  best  handled  as 
general  or  administrative  expenses  to  be  charged  direct  to  profit 
and  loss.  Into  this  list  falls  the  income  tax.  But  property  taxes 
should  be  prorated  over  the  various  component  parts  of  plant  in 
a  way  which  will  permit  their  being  properly  charged  to  plant. 
Some  authorities  class  rent  as  an  expense  not  distributable  as 
indirect.'  Since,  however,  it  merely  displaces  the  expenses 
incident  to  direct  ownership  it  is  better  to  consider  it  as  a  cost  of 
manufacture  and  therefore  distribute  it  over  the  output.  In 
brief,  the  key  to  the  problem,  whether  a  charge  should  be  dis- 

•  E.  S.  Clark  in  Industrial  Management,  Jan.,  1917,  p.  529. 

*  See  Wildman:  Principles  of  Accounting,  pp.  63-4. 

17 


258  ACCOUNTS  IN   THEORY  AND  PRACTICE 

tributed  as  indirect  or  charged  direct  to  profit  and  loss  as  an 
expense  of  administration,  is  the  answer  to  the  question,  is  it  a 
cost  of  manufacture  or  is  it  not?  We  shall  recur  to  this  problem 
later  in  this  chapter. 

Bases  of  Prorating  Indirect  Costs. — We  may  now  consider 
methods  of  distributing  indirect  expense.  Several  bases  of 
doing  this  have  been  advocated.     We  shall  consider  the  following: 

1.  Direct  Labor  3.  Prime  Cost 
(a)  Time  4.  Machine  Rate 
(6)  Cost  (a)  Old  Rate 

2.  Raw  Materials  Cost  (6)  New  Rate 

When  the  direct  labor  method  is  employed  the  indirect  is 
distributed  over  the  various  jobs,  either  on  the  basis  of  the  hours 
of  labor  expended  upon  the  jobs  or  else  upon  the  basis  of  the  cost 
of  labor  expended  upon  them.  When  the  raw  materials  method 
is  employed  the  distribution  is  made  on  the  basis  of  the  cost  of 
raw  materials  entering  into  the  various  jobs.  When  the  prime 
cost  method  is  used  the  basis  is  the  combined  labor  and  raw  ma- 
terials cost.  Under  the  machine  rate  method  indirect  is  dis- 
tributed by  applying  to  each  machine  its  proper  burden  of 
indirect  and  then  distributing  this  indirect  on  the  basis  of  the 
time  during  which  the  machine  is  occupied  on  a  piece  of  work. 

The  Direct  Labor  Method. — For  a  detailed  discussion  of  these 
methods  the  reader  is  referred  to  the  treatises  mentioned  at  the 
end  of  this  chapter.  It  will  suffice  to  mention  here  some  of  the 
advantages  and  defects  of  the  various  plans.  The  first  two 
methods  mentioned  have  simplicity  in  their  favor,  but  the  cases 
in  which  they  serve  as  accurate  bases  for  distribution  of  indirect 
are  not  many.  Certainly,  in  but  few  instances  is  it  true  that  the 
proper  amount  of  indirect  applicable  to  an  order  is  proportionate 
to  either  the  cost  or  the  duration  of  the  direct  labor  expended 
on  that  order.  Indeed,  it  is  oftentimes  the  case  that  the  com- 
parative cost  of  labor  on  products  requiring  a  great  amount  of 
machine  work  is  much  smaller  than  on  those  requiring  much  hand 
work,  although  the  indirect  applicable  to  such  a  job  is  naturally 
greater  because  of  the  machine  work. 

The  Raw  Materials  Method. — Similar  considerations  invali- 
date the  raw  materials  basis  in  most  instances.  In  case  of  the 
highest  grade  products  of  our  factories  raw  material  frequently 
forms  a  rather  small  percentage  of  the  total  cost  of  the  output; 


MANUFACTURING  ACCOUNTING  259 

so  that  it  may  usually  be  said  that  the  proportion  of  indirect 
applicable  to  work  done  is  in  no  way  proportionate  to  the  cost 
of  raw  material  entering  into  the  work. 

The  Prime  Cost  Method. — The  same  objections  that  are  ad- 
vanced against  the  direct  labor  and  the  raw  materials  methods 
of  distributing  indirect  may  be  brought  with  equal  relevancy 
against  the  plan  which  attempts  to  combine  the  two,  namely, 
the  prime  cost  method.  We  need  not  conclude,  of  course,  that 
in  no  instances  are  these  methods  practicable.  Manufacturing 
processes  are  possible  in  which  they  would  serve  satisfactorily; 
but  in  most  cases  they  do  not. 

To  illustrate,  assume  that  two  commodities  are  being  manu- 
factured in  a  factory.  One  is  of  very  simple  construction,  the 
production  of  which  requires  a  prime  cost  of  $500,  made  up  of 
$200  of  labor  and  $300  of  raw  material.  The  time  required  in 
construction  is  brief,  little  milling  and  machining  being  needed. 
The  other  commodity  is  of  a  more  complex  structure,  the  cost 
of  which  consists  to  a  large  degree  of  indirect,  owing  to  the  great 
amount  of  expensive  machine  work  necessary.  The  raw  material, 
however,  costs  but  $100  and  the  labor,  consisting  mostly  of  at- 
tendance upon  and  supervison  of  the  machine  processes,  $75. 
Clearly,  in  this  instance  it  would  be  quite  improper  to  charge 
indirect  to  these  two  commodities  by  the  direct  labor,  raw  mater- 
ials, or  prime  cost  method.  The  indirect  cost,  instead  of  being 
proportionate  to  these,  is  just  the  opposite,  being  large  where 
labor  and  material  cost""  are  small,  and  vice  versa. 


CHAPTER  XXXVIII 
MANUFACTURING  ACCOUNTING—  {Continued) 

The  Machine  Rate  Method — Old  Machine  Rate. — When  the 
machine  rate  is  employed  the  distribution  is  first  made  to  the 
various  departments  and  is  then  distributed  to  the  various 
machines  in  the  departments.  Under  the  old  machine  rate,  the 
indirect  for  the  department  having  been  determined,  it  is  divided 
by  the  actual  number  of  machine  hours  for  the  department  to 
determine  the  rate.  Thus  if  the  indirect  for  department  A  is 
$10,000  and  the  total  number  of  machines  in  department  A  is 
20,  and  each,  when  operating  full  time,  runs  250  hours  in  a  given 
month,  then  the  machine  rate  for  department  A,  for  this  month, 
is  $10,000-=-  (20  X  250)  =  $2.  Consequently,  for  each  hour  that 
a  machine  in  department  A  operates  on  an  order,  that  order  is 
charged  with  $2  for  indirect,  and  so  on. 

A  little  reflection  will  serve  to  indicate  that  this  plan  is  accu- 
rate only  under  more  or  less  extraordinary  circumstances;  that 
is,  when  all  of  the  machines  in  a  department  are  uniform  in  size, 
cost,  and  power  consumption,  and  when  there  is  no  irregularity 
in  the  process,  such  as  bench  work. 

The  New  Machine  Rate. — The  new  machine  rate  plan  ob- 
viates this  difficulty  by  affording  a  still  more  definite  and  direct 
plan  of  allocating  the  indirect.  As  in  the  old  rate  plan,  the  in- 
direct must  be  distributed  first  over  the  departments.  But  a 
step  further  is  then  taken.  Each  machine  is  considered  as  a 
unit,  or  "production  center,"  and  the  indirect  applicable  to  a 
department  is  in  turn  distributed  over  the  various  machines  in 
the  department  on  an  equitable  basis,  as,  for  example,  that  of 
space  occupied.'  Each  machine  is  then  given  a  rate  which  is 
obtained  by  dividing  the  total  indirect  applicable  to  that  machine 
by  the  total  number  of  hours  the  machine  runs  during  the  month, 
no  allowance  being  made  for  idle  time.  The  charge  to  any  given 
order  is  secured  by  multiplying  the  machine  rate  by  the  number 
of  hours  the  machine  operates  on  that  order. 

*  The  basis  varies  with  the  nature  of  the  expense  and  the  character  of  the 
factory.  Thus  electric  lighting  costs  might  be  distributed  on  a  space  basis 
or  on  the  basis  of  the  number  of  bulbs  used. 

260 


MANUFACTURING  ACCOUNTING  261 

Idle  Machine  Time. — However,  it  is  seen  that,  owing  to  the 
impossibiUty  of  keeping  all  machines  running  full  time,  all  of 
the  burden  will  not  be  allocated  to  the  various  orders  operated 
upon.  The  question  arises,  how  shall  the  unallocated  burden 
left  over  as  the  result  of  idle  machine  time  be  charged?  Here 
two  very  definite  and  distinct  theories  have  been  developed.  The 
one  theory,  of  which  the  leading  exponent  and  originator  is  A. 
Hamilton  Church,  advocates  the  distribution  of  this  unapplied 
burden  by  means  of  a  "supplementary  rate"  (secured  by  divid- 
ing the  undistributed  balance  of  indirect  by  the  standard  number 
of  hours  operated  by  all  machines).  This  adds  a  cost  to  all  orders 
proportionate  to  the  machine  hours  spent  on  each,  and  dependent, 
absolutely,  upon  the  amount  of  idle  time.  The  other  theory, 
advocated  by  CUnton  H.  Scovell,  is  to  the  effect  that  the  undis- 
tributed balance  of  burden  resulting  from  idle  machinery  is  not 
an  element  of  cost  of  manufacture,  but  rather  a  general  expense 
or  loss  representing  the  penalty  placed  upon  an  organization 
which  is  unable  to  keep  its  machinery  running  up  to  standard 
full  time.  This  undistributed  burden  ought,  therefore,  to  be 
charged  direct  to  profit  and  loss.^ 

The  indirect  for  any  given  month  is  determined  by  an  estiniate 
based  upon  the  indirect  cost  of  previous  months.  As  a  conse- 
quence, when  the  supplementary  rate  plan  is  employed  and  the 
whole  of  the  estimated  indirect  is  charged  to  the  various  orders 
through  the  primary  machine  rate  and  the  supplementary  rate,  it 
may  be  found  that  the  actual  overhead  for  the  month  differs  from 
the  estimated.  Estimated  overhead  is  employed  because  some 
little  time  may  be  required  to  ascertain  actual  overhead.  When 
actual  overhead  is  determined  an  adjustment  must  be  made  for 
it.  This  then  gives  rise  to  a  second  supplementary  rate,  by  means 
of  which  the  difference  between  the  estimated  and  the  actual 
indirect  is  either  charged  or  credited  to  the  various  orders,  ac- 
cordingly as  the  actual  indirect  is  greater  or  smaller  than  the 
estimated  indirect. '^ 

'  See  the  works  of  Messrs.  Church  and  Scovill  listed  at  the  end  of  this 
part. 

*  The  difference  between  the  actual  and  estimated  indirect,  if  small,  might 
be  added  to  the  indirect  of  the  succeeding  month ;  or  if  it  is  possible  to  delay 
distribution  of  indirect  until  actual  indirect  for  the  month  is  learned,  no  such 
undistributed  balance  occurs.  What  follows  in  this  chapter  is  said  subject  to 
this  qualification. 


262  ACCOUNTS  IN  THEORY  AND  PRACTICE 

To  illustrate,  assume  that  the  total  number  of  machine  hours 
for  a  given  machine,  running  full  time,  is  360  for  a  given  month, 
and  that  the  total  indirect  applicable  to  that  machine  is  esti- 
mated to  be  $720  for  that  month.  Its  rate  per  hour  is,  therefore, 
720-7-360  or  $2.  But  if  idle  time  for  the  month  for  this  machine 
amounts  to  60  hours,  the  unapplied  portion  of  the  estimated 
burden  will  amount  to  2  X  60  or  $120.  Further,  let  us  assume 
that  in  due  time  the  actual  indirect  for  this  month  is  ascertained 
to  be  $780,  or  $60  in  excess  of  the  estimated  indirect.  To  simpli- 
fy matters  for  illustrative  purposes  assume  further  that  the 
machine's  time  during  the  month  has  been  occupied  exclusively 
upon  four  order  numbers.  Below  is  shown  the  appearance  of 
the  account  for  indirect  and  also  the  cost  ledger  accounts  for  the 
four  orders,  after  the  indirect  has  been  distributed,  first  by  the 
direct  rate,  secondly,  by  the  first  supplementary  rate,  and, 
thirdly,  by  the  second  supplementary  rate: 

General  Ledger 
Indirect,  Dep't.     A. 

Actual  Indirect $780         Direct  rate $G00 

1st  Supplementary  ., 120 

2nd  Supplementary 60 

$780  S780 

Cost  Ledger 

Order  No.  230  (70  hrs  .) 

Direct  Rate $140.00 

1st  Supplementary 28.00 

2nd  Supplementary 14 .  00 

Order  No.  231  (100  hrs.) 

Direct  Rate 200 .  00 

1st  Supplementary 40 .  00 

2nd  Supplementary 20 .  00 

Order  No.  232  (70  hrs.) 

Direct  Rate $140.00 

1st  Supplementary 28.00 

2nd  Supplementary 14 .  00 

Order  No.  233  (60  hrs.) 

Direct  Rate $120.00 

1st  Suppementary 24 .  00 

2nd  Supplementary 12 .  00 

The  hours  indicated  within  the  parentheses  are  the  actual 
number  of  hours  spent  by  the  machine  on  the  different  orders. 
The  "direct  rate"  charge  is  made  on  the  supposition  that  the 
machine  operates  full  time.  The  "1st  supplementary"  charge 
distributes  the  balance  of  estimated  indirect  resulting  from  idle 
time.     The  "2nd  supplementary"  charge  distributes  the  excess 


MANUFACTURING  ACCOUNTING  263 

of  the  actual  over  the  estimated  indirect.  The  "  1st  supple- 
mentary" rate  is  secured  by  dividing  the  unapplied  burden 
resulting  from  idle  time,  $120,  by  the  number  of  operating  ma- 
chine hours  for  the  month,  300,  which  gives,  as  the  first  supple- 
mentary rate  per  hour,  $0.40.  The  "2nd  supplementary"  rate 
is  secured  by  dividing  the  excess  of  the  actual  indirect  over  the 
estimated  indirect,  $60,  by  the  number  of  operating  machine 
hours  for  the  month,  300,  which  gives  as  the  second  supplementary 
rate  per  hour,  $0.20.  The  various  distributions  are  shown  in  the 
above  accounts. 

Use  of  Clearing  Accounts. — In  actual  practice  the  account  for 
indirect  would  be  either  in  the  form  of  one  general  clearing 
account  in  the  General  Ledger,  or  else  there  would  be  set  up 
separate  accounts  for  indirect  for  the  various  departments. 
Since  the  estimated  indirect  is  charged  to  the  various  order 
numbers  before  the  actual  indirect  is  determined  the  general 
ledger  indirect  account  would  be  credited  with  the  amount  of  the 
estimated  indirect  before  being  charged  with  the  actual  indirect. 
At  the  time  the  various  order  numbers  are  charged  with  their  due 
proportion  of  indirect  as  determined  by  the  direct  machine  rate, 
an  entry  is  made  in  the  General  Journal  debiting  manufacturing 
account  (controlling  the  Cost  Ledger)  and  crediting  the  account  for 
indirect.     Thus,  for  the  example  suggested  above  the  entries  are: 

Manufactuiing   ...  $600.00 

To  Indirect,  Dept.  A $600.00 

When  the  amount  of  the  first  supplementary  is  determined 
the  following  entry  is  in  order  in  the  General  Journal: 

Manufacturing $120.00 

To  Indirect,  Dept.  A $120. 00 

Finally,  when  the  second  supplementary  is  determined  the  fol- 
lowing entry  is  made: 

Manufacturing     $60 .  00 

To  Indirect,  Dept.  A $G0.00 

Departmental  Indirect. — Before  the  last  entry  above  is  made, 
however,  the  departmental  indirect  account  is  charged  with  the 
actual  amount  of  indirect  for  the  month.  The  procedure  by 
which  this  actual  charge  for  indirect  finds  its  way  to  the  various 
departmental  indirect  accounts  is  as  follows.  All  indirect 
expenses   which   can   be   computed   on   a   direct   departmental 


264  ACCOUNTS  IN   THEORY  AND  PRACTICE 

basis  are  charged  to  proper  departmental  accounts.  Thus 
we  may  assume  that  at  the  close  of  the  month  the  departmental 
expense  accounts  of  Department  A  show  the  following  charges: 

Supplies,  debited  with  

Maintenance,  debited  with  

Wages  of  janitors,  debited  with  

Lighting,  debited  with  • 

While  accounts  for  the  factory  as  a  whole  are  charged  as  follows; 

Taxes,  debited  with  

Insurance,  debited  with  '       

Depreciation,  debited  with  

Heating,  debited  with  

These  are  merely  put  down  thus  for  illustrative  purposes.  The 
classification  of  such  accounts  on  a  departmental  or  a  general 
factory  basis  varies  with  conditions.  If,  however,  the  above  is 
the  accepted  basis,  then  to  transfer  these  delpit  balances  to  the 
departmental  indirect  accounts  the  following  journal  entries  are 
necessary: 

Indirect,  Dep't.  A 

To  Supplies,  Dep't.  A 

Maintenance,  Dep't.  A 

Wages  of  Janitors,  Dep't.  A 

Lighting,  Dep't.  A 

To  carry  the  departmental  expense   charges 
to  the  clearing  account  for  indirect. 

Indirect,  Dep't.  A.  }4 

Indirect,  Dep't.  B.  K 

Indirect,  Dep't.  C.  K 

To  Taxes,  whole  factory 

Insurance,  whole  factory     

Depreciation,  whole  factory 

Heating,  whole  factory 

To  distribute  the  various  general  factory  ex- 
penses to  the  departmental  indirect  accounts. 

The  various  expenses  are  distributed  on  some  proper  basis; 
of  course  the  different  ones  need  not  be  distributed  in  the  same 
proportion  to  the  different  departments.  In  this  way  each 
departmental  indirect  account  is  charged  with  the  department's 
due  proportion  of  such  indirect,  and  this  is  in  turn  charged  to 
manufacturing,  as  has  already  been  shown. 

Criticism  of  Supplementary  Rate  Plan. — The  attitude  of  those 
who  criticize  the  supplementary  rate  plan  may  best  be  shown  by 
the  following  quotation  from  Scovell: 


MANUFACTURING  ACCOUNTING  265 

"Under  the  old  and  familiar  percentage-on-wages  method,  as  usually 
applied,  or  with  the  cumbersome  and  unsound  supplementary  rate,  the 
costs  seem  low  during  periods  of  active  production,  while  during  periods 
of  curtailed  production  costs  seem  high,  since  all  of  the  burden  is  dis- 
tributed over  a  greater  or  less  volume  of  manufacture.  Thus  a  varying 
production,  which  is  entirely  beyond  the  control  of  foremen  and  opera- 
tives apparently  affects  the  cost  of  work  done  by  them."  Further, 
"contrary  to  the  general  practice  stated  above,  the  fact  is  that  only  a 
part  of  the  total  burden  is  chargeable  to  the  manufacturing  cost  of 
the  product  made  during  periods  of  curtailed  production,  the  part 
chargeable  being  the  same  percentage  of  the  total  burden,  as  the  cur- 
tailed production  is  of  the  standard  production. "* 

It  is  difficult  to  understand  why  the  cost  of  a  product  should 
be  increased  by  being  charged  with  the  cost  of  idle  machine 
time.  To  do  so  establishes  costs  without  a  standard  and  which 
will  continue  to  change,  not  with  the  rise  and  fall  of  labor  and 
materials,  but  with  the  changes  in  the  amount  of  work  the  factory 
may  be  fortunate  in  obtaining.  The  products  of  busy  machines 
are  penalized  for  the  expense  of  upkeep  of  idle  machines.  The, 
cost  of  idleness  is  shown  as  a  cost  of  manufacture.  If  on  the 
other  hand,  the  unapplied  indirect  were  charged  direct  to  profit 
and  loss  as  a  general  expense  not  distributable,  it  would  at  once 
serve  as  a  convenient  measure  of  the  loss  due  to  part  time  oper- 
ations and  thus  afford  a  useful  index  of  manufacturing  efficiency. 

Unapplied  Indirect  Charged  to  Profit  and  Loss. — Under  this 
plan  the  distribution  of  the  indirect  in  the  example  cited  above 
is  accomplished  as  follows : 

General  Ledger 

Indirect,  Dep't.  A 

Actual  Indirect $780         Direct  Plate $600 

Profit  and  Loss 180 

$780  $780 

Cost  Ledger 
Order  No.  230  (7  hrs.) 

Direct  Rate $140 

Order  No.  231  (100  hrs.) 

Direct  Rate $200 

X    Order  No.  232  (70  hrs.) 

Direct  Rate $140 

Order  No.  233  (60  hrs.) 
Direct  Rate $120 

'  Cost  Accounting  and  Burden  Application,  p.  70. 


266  ACCOUNTS  IN  THEORY  AND  PRACTICE 

According  to  this  method  each  order  is  charged  with  only  that 
proportion  of  indirect  which  would  be  applicable  were  there  no 
idle  machine  time.  As  a  consequence  the  cost  of  a  manufactured 
article  is  not  affected  by  idle  time,  all  unapplied  indirect  being 
charged  directly  to  profit  and  loss.  This  plan  does  not,  of  course, 
remove  the  discrepancy  between  estimated  and  actual  burden, 
which  may  be  distributed  on  a  basis  similar  to  that  already 
suggested,  or  if  it  is  small  it  may  be  carried  to  profit  and  loss 
direct  or  else  added  to  the  following  month's  indirect.  It 
will  be  used  of  course  in  making  the  estimate  of  the  next  month's 
indirect. 

Transfer  to  Finished  Goods. — When  an  order  number  in  the 
Cost  Ledger  has  been  charged  with  direct  labor,  raw  materials, 
and  indirect  for  the  month,  its  monthly  record  of  cost  is  com- 
plete. When  all  elements  of  cost  entering  into  its  production, 
continuing  over  a  more  Or  less  extended  period  of  time,  are  entered 
in  the  Cost  Ledger,  a  complete  record  of  cost  is  furnished.  The 
next  step  is  to  indicate  the  accounting  procedure  required  to 
record  the  transfer  of  the  finished  product  from  the  factory  to  the 
stock-room  or  finished  goods  department. 

As  a  record  of  finished  goods  on  hand,  a  Finished  Goods  Ledger 
should  be  kept,  controlled  by  the  finished  goods  controUing  ac- 
count in  the  General  Ledger.  When  goods  are  transferred  from 
the  factory  to  the  finished  goods  department  the  proper  accounts 
in  the  Cost  Ledger  are  credited  and  at  the  same  time  detailed 
charges  are  made  in  the  Finished  Goods  Ledger,  at  cost  price. 
For  the  total  of  goods  thus  transferred  during  the  month  a  sum- 
mary entry  is  made  in  the  General  Journal  and  posted  to  the 
proper  controlling  accounts,  thus: 


Finished  Goods  (controlling  account) 

To  Manufacturing  (controlling  account). 


Sale  of  Goods. — Finally,  as  the  finished  products  are  sold  the 
detailed  accounts  in  the  Finished  Goods  Ledger  are  credited, 
while  for  the  total  monthly  sales  entries  are  made,  crediting  the 
finished  goods  controlling  account  and  charging  profit  and  loss 
with  the  cost  of  goods  sold,  thus: 

Profit  and  Loss 

To  Finished  Goods 


MANUFACTURING  ACCOUNTING  267 

From  this  point  the  procedure  is  not  dififerent  from  that  of  the 
ordinary  trading  concern.' 

Advantages  of  a  Cost  System. — 1 .  As  an  Aid  in  Contract  Work. — 
In  determining  the  price  at  which  he  is  wilhng  to  undertake  the 
execution  of  a  piece  of  work,  the  experience  with  past  costs  is  of 
most  value  to  a  contractor,  if  accurate  records  have  been  kept. 
When  such  records  are  non-existent  price-making  is  haphazard 
and  hable  to  be  conditioned  more  upon  what  a  competitor  may 
offer  than  upon  a  suitable  margin  of  profit.  Such  procedure  has 
nothing  to  recommend  it.  Sometimes  it  may  be  necessary  to 
sell  below  cost,  but  it  should  be  done  only  with  a  full  compre- 
hension of  the  facts.  Perhaps  a  competitor  may  be  selling  below 
cost.  Such  competition,  when  continued  long  enough,  extin- 
guishes itself.  There  is  but  one  adequate  basis  upon  which  to 
determine  prices — accurate  cost  data. 

2.  As  an  Aid  in  Preparing  Monthly  Statements. — An  adequate 
cost  system  necessitates  the  keeping  of  accurate  book  inventories. 
A  book  or  perpetual  inventory  differs  from  a  physical  inventory. 
The  latter  is  taken  at  the  close  of  an  accounting  period  by  means 
of  an  actual  count.  A  perpetual  inventory,  on  the  other  hand, 
consists  of  detailed  records  of  goods  so  kept  that  they  at  all  times 
furnish  the  needed  information  as  to  their  kind  and  quantity. 
Forms  are  provided  upon  which  are  entered  the  additions  to  and 
deductions  from  any  given  class  of  goods.  In  manufacturing 
accounting  perpetual  inventories  should  be  kept  for  three  classes 
of  commodities — raw  materials,  goods  in  process,  and  finished 
goods.  These  book  inventories  do  not  dispense  with  the  neces- 
sity of  physical  inventories,  but  they  lessen  the  burden  of  taking 
them  by  making  it  possible  to  take  them  at  times  when  work  of 
other  kinds  is  not  pressing. 

When  all  postings  from  journals  have  been  made  the  balances 
of  the  three  controlling  accounts,  raw  materials,  manufacturing, 
and  finished  goods,  represent  the  totals  of  the  raw  materials, 
goods  in  process,  and  finished  goods  inventories,  respectively. 
Even  were  monthly  physical  inventories  feasible  the  delay  in- 
curred would  be  considerable.  Perpetual  inventories  avoid  this. 
At  intervals  the  book  or  perpetual  inventory  should  be  checked 

*  In  the  income  statement  it  is  customary,  of  course,  to  detail  the  elements 
entering  into  cost — taxes,  depreciation,  wages,  insurance,  fuel,  etc.;  also 
to  show  the  effect  on  earnings  of  changes  in  inventories  of  raw  materials, 
goods  in  process,  and  finished  goods. 


268  ACCOUNTS  IN   THEORY  AND  PRACTICE 

up  by  a  physical  inventory  and  errors  adjusted.  One  of  the 
most  important  qualities  of  the  monthly  income  statement  is  its 
timeliness.     To  this  perpetual  inventories  are  essential. 

3.  Locating  Leaks  and  Inefficient  Procedure.  —Any  discrepancy 
between  book  and  physical  inventories  is  investigated.  Such  a 
check  on  the  keeper  of  the  raw  materials  serves  as  an  incentive 
to  carefulness  on  his  part.  Sometimes  unprofitable  processes 
or  departments  are  sustained  by  profitable  ones.  By  learning 
costs  with  exactness  these  unprofitable  lines  are  located  and  may 
be  discontinued  or  made  efficient  by  introducing  needed  changes. 

4.  Moral  Effect. — When  a  foreman  knows  that  his  department 
is  being  compared  with  other  departments  on  an  exact  basis  he 
employs  all  of  his  influence  to  lower  costs  and  increase  production. 
He  economizes  on  raw  materials  and  supplies.  He  returns  all 
unused  raw  material  to  the  storeroom  for  credit  to  his  depart- 
ment. A  scientific  supervision  is  established  and  merit  is  re- 
warded.    Favoritism  is  made  impossible  and  endeavor  profitable. 


CHAPTER  XXXIX 

MANUFACTURING  ACCOUNTING— PRACTICE 

Problem  1. — 

Following  is  the  trial  balance  of  the  Ironton  Manufacturing 
Company  as  at  Dec.  21,  1919: 

Purchases  of  Raw  Materials $14,500.00 

Inventories:    Raw  Materials 2,100.00 

Goods  in  Process 1,900.00 

Finished  Goods 1,271 .  40 

Wages 8,999.25 

Sales $18,128.40 

Expease,  factory 312 .  00 

Discount  on  Purchases 348.00 

Allowances  to  Customers 187 .  40 

Rentals 340.00 

General  Expense 411.41 

Insurance  (current) 418.00 

Cartage  Out 144.00 

Commissions 188 .  00 

Notes  Receivable 5,000.00 

Accounts  Receivable 5,890. 15 

Petty  Cash 100.00 

Cash  in  Bank 5,491 .  17 

Factory:    Tools 3,000.00 

Drawings  and  Models 1,200 .  00 

Machinery 6,800. 00 

Notes  Payable 9,700. 00 

Capital  Stock  Outstanding 20,000 .  00 

Surplus 10,076.38 


$58,252.78^  $58,252.^ 

The  inventories  Dec.  31,  1919  are: 

Raw  Materials $  2,121 .50 

Goods  in  Process 10,100.00 

Finished  Goods 4,040.00 


$16,261.50 


The  company  has  been  operating  for  about  three  years.     The 
books  were  last  closed  as  of  Dec.  31,  1918,  but  nothing  has  been 

269 


270  ACCOUNTS  IN   THEORY  AND  PRACTICE 

written  off  for  depreciation  of  tools,  drawings  and  models,  and 
machinery.     A  reserve  for  bad  debts  of  $100  should  be  set  up. 

Prepare  such  statements  as  are  necessary  to  show  the  worth 
of  the  outstanding  capital  stock. 

Problem  1 — Solution. — To  show  clearly  the  progress  made 
during  the  year  and  the  present  financial  condition  of  the  com- 
pany it  will  be  necessary  to  set  up  an  income  statement  and  a 
balance  sheet.  The  amount  of  depreciation  to  be  written  off  on 
tools,  drawings  and  models,  and  machinery  is  optional.  We 
shall  assume  that  $1500  for  tools,  $700  for  drawings  and  models, 
and  $2000  for  machinery,  represent  the  depreciation  for  the  past 
two  and  one-half  years.  Only  one  year's  depreciation  should  be 
charged  to  operations  for  the  current  year,  and  the  remainder 
should  be  carried  direct  to  surplus  because  it  should  have  been 
charged  off  previously  to  the  current  year. 

The  income  statement  follows : 


Income  Statement,  Ironton  Manufacturing  Co. 
for  year  ending  Dec.  31,  1919 : 

Mavufacturing  Section 

Inventories  Dec.  31,  1918:  Balance,     Cost     to 

Manufacture $15,259. 15 

Raw  Materials S  2,100.00 

Goods  in  Process 1,900.00 

Finished  Goods 1,271.40 

$  5,271.40 
Purchases 14,400.00 

$19,771.40 
Less  Inventories  Dec.  31,  '19: 

Raw  Materials $  2.121 .50 

Goods  in  Process 10,100.00 

Finished  Goods 4,040.00 

$16,261.50 

Cost  of  Raw  Materials $  3,509.90 

Wages 8,999.25 

Expense,  factory 312.00 

Rentals 340.00                                                                     ^ 

Insurance 418.00 

Depreciation:     Tools 600.00 

Drawings      and 

Models 280.00 

Machinery 800.00 


$15,259.16  $15,259.15 


MANUFACTURING  ACCOUNTING— PRACTICE 


271 


Trading  Section 

Balance,  Cost  to  Manufacture..   $15,259.15     Sales 

Allowances  to  Customers 187.40 

Cartage  Out 144.00 

Commissions 188 .  00 

Balance,  Trading  Profit 2,349 .  85 


.$18,128.40 


$18,128.40 


$18,128.40 


Profit  and  Loss  Section 

General  Expense $    411.51     Balance,  Trading  Profit $2,349.85 

Balance,  Net  Profit  to  Surplus 2,286.44     Discount  on   Purchases 348.00 


$2,697.85 


The  balance  sheet  follows: 


Balance  Sheet,  Ironton  Manufacturing  Co. 
as  at  Dec.  31,  1919 : 


Inventories: 

Raw  Materials 

Goods  in  Process. . 

Finished  Goods... . 

Toola 3,000.00 

Lea<  R^.  for  Dep .  .    1,500.00 


Drawings 1,200.00 

LeM  Res.  for  Dep.  .       700.00 


2,121.50  7556.38 

10,100.00  Add  Net  Profit,  1919.  2286.44 
4,040.00 

1,500.00 


500.00 


Machinery 6,800.00 

Le»a  Res.  for  Dep.  .    2,000.00 


4,800.00 


$39,542.82 


$2,697.85 


Notes  Receivable 

$  6,000.00  Capital     Stock     Out- 

standing   

$20,000.00 

Accounts  Receivable. 

5,890. 15  Notes  Payable 

9.700.00 

Petty  Cash 

100.00  Surplus  Dec.  31,  1918.10076.38 

Cash  in  Bank 

5,491.17  Less  Depreciation  1>^ 

yrs 2520.00 

9,842.82 


$39,542.82 


The  wasting  assets  have  been  written  down  to  a  conservative 
basis  and  all  proper  expenses  have  been  charged  against  the 
current  year's  costs  of  operation.  As  a  result  the  net  profits 
for  the  current  year  are  something  over  11  %  on  the  capital  stock 
outstanding  and  something  over  8%  on  net  capital  invested, 
i.e.,  capital  stock  outstanding  plus  surplus. 

For  each  share  of  outstanding  stock  (par  value  $100)  there 
exists  a  net  investment  of  $137.78  which,  as  nearly  as  can  be 
ascertained  from  the  data  available,  is  the  value  of  the  stock  per 
share. 


272  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Problem  2. — The  trial  balance  of  the  Williams-Allen  Manu- 
facturing Company,  as  at  Dec.  31,  1919,  is  as  follows: 

Raw  Materials,  12/31/18 $  90,000.00 

Goods  in  Process  12/31/18 30,000.00 

Finished  Goods  12/31/18 25,000.00 

Factory  Wages 75,000.00 

Sales 500,000.00 

Purchases  (raw  materials) 160,000.00 

Factory  Expense 50,000.00 

Purchase  Discounts 6,000. 00 

Rentals  (office  space) *                  2,000.00 

Factory  Insurance  (current) 3,000 .  00 

Freight  Out 1,000.00 

Selling  Expenses 26,000.00 

Investments 60,000.00 

Accounts  Receivable 42,000.00 

Cash 7,000.00 

Factory  Building 220,000.00 

Machinery 135,000.00 

Tools 20,000.00 

Capital  Stock : 

Common 200,000.00 

Preferred  (6  %  cumulative) 100,000 .  00 

Surplus 36,000.00 

Bonds  (1st  Mortgage) 100,000.00 

$944.000.00    $944,000.00 

Inventories  Dec.  31,  1919: 

Raw  Materials $100,000 .  00 

Goods  in  Process 25,000 .  00 

Finished  Goods 31,000. 00 

$156,000.00 

The  company  began  operations  two  and  one-half  years  ago 
and,  except  for  the  current  year,  adequate  depreciation  allowances 
have  been  made  on  all  wasting  assets.  Instead  of  being  credited 
to  depreciation  reserves  these  allowances  were  credited  directly 
to  the  asset  accounts,  so  that  the  amounts  shown  indicate  cost 
less  depreciation.  You  are  requested  to  submit  an  opinion 
upon  the  value  of  the  preferred  stock,  which  has  a  par  value  of 
$100  per  share.  Show  how  you  arrive  at  this  opinion.  Submit 
an  income  statement  and  a  balance  sheet. 


CHAPTER  XL 
RELATION  OF  ACCOUNTING  TO  MANAGEMENT 

Purpose  of  Accounts. — The  chief  usefulness  of  accounts  begins 
where  the  routine  work  of  creating  them  ends.  Too  frequently 
the  accounts  are  regarded  as  an  end  in  themselves  rather  than  as 
a  means  of  promoting  more  efficient  management.  An  account- 
ing system  must  afford  not  only  a  complete  record  of  details 
regarding  accounts  receivable  and  payable,  inventories,  un- 
collectible accounts,  and  all  other  pertinent  financial  data  which 
compose  the  history  of  a  concern's  operations;  it  must  also 
supply  live  information  to  the  manager  of  such  a  character 
as  will  enable  him  to  deal  efficiently  with  present  and  future 
problems. 

Information  the  Manager  Needs.^ — The  problems  which  con- 
front the  manager  are,  roughly,  those  which  refer  to  strictly 
internal  conditions — departmental  efficiency,  waste,  amount  of 
turnover,  and  so  on;  and  those  which  arise  in  connection  with  the 
outer  world — price  making,  contracts,  taxation,  and  so  on.  He 
requires  all  information  which  will  aid  him  in  arriving  at  an 
accurate  and  businesslike  solution  of  these  problems.  Much  of 
this  information  must  be  furnished  by  the  accountant,  who,  if 
he  makes  the  most  of  his  opportunities,  will  find  his  services  in 
constant  demand  for  supplying  this  useful  information  to  the 
executive  department. 

The  Balance  Sheet  and  Income  Statement. — Much  informa- 
tion can  be  derived  by  the  manager  from  a  study  of  the  current 
balance  sheet  and  the  income  statement.  Moreover,  the  useful- 
ness of  these  statements  is  greatly  increased  if  they  are  presented 
in  such  form  as  will  enable  the  making  of  comparisons  between 
periods.  This  is  emphatically  true  of  the  income  statement. 
Many  corporation  reports  present  these  in  comparative  arrange- 
ment. Sometimes  balance  sheets  for  successive  periods  are 
also  presented  in  comparative  form.  Forms  of  comparative 
income  statements  are  shown  on  pages  203  and  206. 

The  usefulness  of  such  comparative  statements  is  limited. 
They  do  not  show  all  of  the  information  that  the  manager  requires 
18  273 


274  ACCOUNTS  IN  THEORY  AND  PRACTICE 

and  they  do  not  emphasize  vital  tendencies.  It  becomes  neces- 
sary, therefore,  to  contrive  means  not  only  of  presenting  all 
figures  and  facts  needed  by  the  manager  or  executive,  but  of 
presenting  these  in  such  form  that  changes  and  tendencies  are 
emphasized  and  that  the  greatest  amount  of  information  may 
be  secured  with  the  least  expenditure  of  time  and  effort. 

Character  of  Reports. — Cost  systems  sometimes  fail  because 
cordial  cooperation  is  lacking  between  the  accountant  and  the 
manager.  Without  this  such  reports  lose  much  in  value.  The 
skillful  manager  will  regard  them  as  a  means  of  control  over 
departments  and  processes.  His  attitude  must  determine, 
largely,  to  what  degree  the  cost  system  is  to  be  an  instrument  of 
control. 

Reports  to  the  manager  may  be  either  statistical  and  tabular 
in  form,  or  graphic,  or  the  two  methods  may  be  combined. 
Ordinarily  the  graphic  method  will  be  found  less  satisfactory 
than  the  tabular  method,  for  routine  purposes,  although  there 
may  be  exceptions  to  this  rule.  The  manager  should  be  suffi- 
ciently familiar  with  conditions  and  tendencies  to  interpret  sta- 
tistics, and  the  presentation  of  many  graphs  might  lead  to 
unpleasant  results.  The  use  of  graphs  should  be  limited  to  the 
explanation  of  the  more  important  tendencies  of  business  which 
necessitate  the  consideration  of  considerable  periods  of  time; 
such,  for  example,  as  the  amount  of  net  sales  from  month  to 
month,  the  relationship  between  sales  and  net  profits  in  different 
periods,  and  the  variations,  from  period  to  period,  of  purchases, 
sales,  and  inventories.  By  proper  planning  such  graphs  may  be 
made  continuing  in  character,  additions  being  made  as  the  latest 
results  of  operations  are  reported. 

Expression  by  Percentages. — Within  certain  limitations  per- 
centages may  be  employed  to  bring  significant  relationships  and 
changes  before  the  mind.  Being  related  to  a  common  base  of 
100  they  afford  a  better  mode  of  comparison  than  do  sums  ex- 
pressed in  quantities  of  dollars,  or  other  concrete  units  of  measure- 
ment. Thus,  if  we  try  to  distinguish  the  relative  significance 
of  two  sums  of  money,  $1728.40  and  $1423.80,  we  are  aided  by 
being  informed  that  the  latter  amount  is  82.3+  %  of  the  former 
amount.  Or  if  we  wish  to  compare  a  ship  of  19,000  tons  burden 
with  one  of  12,000  tons  burden  we  are  aided  in  making  the  com- 
parison by  knowing  that  the  smaller  tonnage  is  63.1+  %  of 
the  larger.     That  percentages  must  be  carefully  related  to  a 


RELATION  OF  ACCOUNTING  TO  MANAGEMENT        275 

common    base,  however,  will  appear  from  the  considerations 
which  follow. 

Problem  of  Price-making. — One  of  the  most  important  duties 
of  the  executive  is  to  fix  prices  that  will  enable  him  to  meet  com- 
petition and  still  make  a  suitable  profit.  Haphazard  price- 
making  is  a  frequent  cause  of  insolvency  and  bankruptcy, 
especially  when  competition  is  keen  and  costs  inaccurate.  Vari- 
ous factors — business  customs,  changing  fashions,  credit  condi- 
tions, and  so  on — enter  to  complicate  the  problem  of  price-making. 
These  external  factors  do  not  enter  directly  into  the  accounts 
but  they  do  affect  materially  the  use  which  can  be  made  of  the 
results  which  the  accountant  secures. 

Even  when  costs  are  accurately  kept  the  method  of  fixing  the 
selling  price  is  often  misunderstood.  It  has  been  estimated  that 
out  of  every  one  hundred  individuals  who  engage  in  the  retail 
business  only  five  succeed.  This  great  proportion  of  failures 
is  unquestionably  due  in  part  to  ignorance  of  capital  requirements 
and  of  correct  methods  of  calculating  profits  on  the  capital 
invested. 

The  real  cost  of  doing  business  is  apt  to  be  overlooked  by  the 
small  enterpriser  because  of  his  failure  to  possess  accurate  in- 
formation as  to  the  more  intangible  elements  of  cost,  such,  for 
example,  as  contingencies  and  depreciation.  Items  of  expense 
for  which  immediate  payment  must  be  made,  such  as  rent,  heat, 
light,  wages,  advertising,  insurance,  and  freight  are  usually 
accounted  for  with  a  fair  degree  of  accuracy ;  but  not  so  those  of  a 
less  definite  character  such  as  the  unavoidable  depreciation  of 
stock,  fixtures  and  real  estate,  as  well  as  depreciation  of  stock 
resulting  from  overbuying  or  errors  in  buying,  losses  caused  by 
dishonest  employees,  bad  debts,  losses  on  special  sales  and  so 
forth. 

Profits  Based  on  Selling  Price. — Not  only  is  there  a  likelihood 
that  the  merchant  will  understate  costs  of  doing  business;  he 
frequently  adopts  the  erroneous  policy  of  calculating  his  profits 
on  cost  instead  of  selling  price,  with  the  result  that  a  policy  which 
is  wrong  in  itself  is  aggravated  by  understatement  of  costs  upon 
which  the  profits  are  figured.  Having  established  his  cost  at  an 
amount  below  that  which  greater  care  would  have  determined,  the 
merchant  proceeds  to  find  the  selling  price  which  will  afford  him 
the  desired  percentage  of  profit. 

To  illustrate,  let  us  assume  that  the  true  cost  of  a  commodity 


276  ACCOUNTS  IN  THEORY  AND  PRACTICE 

is  $10  and  that  the  merchant  decides  to  sell  it  for  $12.50.  This 
is  an  increase  of  25  per  cent  on  the  cost  price  but  only  20  per  cent 
on  the  selling  price.  This  means  that  if  the  merchant  reckons 
his  operating  expenses  as  a  percentage  of  gross  sales,  which  is 
customary  practice,  while  he  at  the  same  time  figures  his  profits 
as  a  percentage  of  cost  of  goods,  he  is  working  with  two  different 
standards — with  financial  difficulties  for  his  reward. 

Thus,  if  the  income  statement  shows  that  the  expenses  of 
operation  amount  to  20  per  cent  of  sales  and  the  merchant  con- 
cludes that  a  net  profit  of  5  per  cent  will  be  satisfactory  and  so 
proceeds  to  write  up  his  goods  25  per  cent  above  cost,  he  is  ulti- 
mately surprised  to  find  that  he  has  made  no  profit  at  all.  He 
discovers  that  25  per  cent  of  100  is  but  20  per  cent  of  125,  the 
selling  price,  which  is  just  sufficient  to  cover  costs  of  operating. 
He  errs  by  reckoning  his  percentage  of  profit  on  cost  and  his 
percentage  of  operating  expense  on  selling  price. 

The  Problem  Illustrated. — A  merchant  buys  a  commodity  for 
$1.  His  operating  expenses  are  20  per  cent  of  gross  sales.  He 
wishes  to  make  a  net  profit  of  8  per  cent.^  What  should  be  the 
selling  price  of  the  commodity? 

Solution: 

100  -  (20  +  8)  =  72 
$1  -^  72  =  $1.39  Answer. 

All  problems  of  a  similar  character  may  be  solved  by  the  follow- 
ing rule:  To  the  operating  expense  add  the  net  profit  desired, 
both  expressed  as  percentage  figures.  Deduct  this  sum  from 
100  per  cent.     Divide  the  cost  of  the  article  by  the  difference. 

Selling  Price  the  Proper  Basis. — The  common  error  lies  in  the 
failure  to  distinguish  the  selling  price  as  the  proper  figure  upon 
which  to  base  all  percentages  of  expense  and  profit;  so  that  some- 
times an  attempt  is  made  to  work  both  from  the  sales  basis  and 
the  cost  basis.  As  has  been  well  said,  "many  business  men 
seem  to  have  persistently  refused  to  acknowledge  that  any  per  cent 

of  a  smaller  sum  is  a  smaller  per  cent  of  a  larger  sum or  to 

put  it  concretely,  that  if  25  is  25%  of  100  it  is  only  20%  of  125 
and  25%  increase  over  cost  is  20%  profit  on  the  selling  price." 

This  leads  to  a  consideration  of  the  reasons  for  employing 
sales  instead  of  costs  as  a  basis  upon  which  to  figure  profits.     Re- 

*  Note  that  per  cent,  of  net  profit  here  refers  to  cost  or  to  selling  price,  not 
to  investment  of  capital. 


RELATION  OF  ACCOUNTING  TO  MANAGEMENT        277 

flection  will  reveal  that  no  other  single  item  bears  such  a  signifi- 
cant relationship  to  the  various  activities  of  an  enterprise.  Upon 
the  amount  of  the  sales  depend  all  other  functions  and  activities. 
When  sales  are  of  satisfactory  volume,  with  a  duly  large  margin 
of  income  over  expenditure,  the  goal  of  all  the  many  activities  is 
reached.  As  a  consequence  the  amount  of  the  sales  of  an  enter- 
prise is  made  the  basis  of  various  calculations.  Net  sales  deter- 
mines the  amount  of  revenue  applicable  to  payment  of  costs, 
expenses,  and  a  suitable  return  for  investment  and  management. 
The  remuneration  of  salesmen,  for  example,  is  figured  as  a 
percentage  of  sales.  Why,  then,  consider  profit  as  a  percentage 
of  cost? 

The  significance  of  this  is  the  emphasis  it  throws  on  the  method 
employed  in  fixing  selling  prices.  To  illustrate,  assume  that  a 
grocer  finds  that  the  cost  of  doing  business  amounts  to  18  per 
cent  of  net  sales.  He  wishes  to  learn  whether  he  can  make  a 
profit  of  10  per  cent  on  a  given  commodity  and  sell  at  the  market 
price.     He  reasons  as  follows : 

The  cost  of  the  article  is  $1.50.  To  this  he  must  add  18  -f  10 
or  28  per  cent  to  cover  cost  of  doing  business  and  provide  the 
desired  profit.  To  $1.50  he  adds  28  per  cent  of  $1.50,  or  $0.42, 
which  gives  $1.92  as  the  selling  price. 

Note  the  error  in  this  calculation.  The  cost  of  doing  business 
is  18  per  cent  of  net  sales,  but  18  per  cent  of  $1.92  is  $0.35,  which 
deducted  from  the  selhng  price,  $1.92,  leaves  $1.57  to  cover  cost 
and  provide  the  net  profit  desired.  The  excess  of  $0.07  above 
cost  does  not  give  the  merchant  a  profit  of  10  per  cent — not  even 
on  cost.  The  confusion  arose  from  a  failure  to  employ  net  sales 
as  the  basis  from  which  to  compute  all  percentages. 

Employing  the  rule  given  above  we  find  that  the  correct  selhng 
price  to  provide  10  per  cent  net  profit  and  cover  expenses  of  18 
per  cent  is: 

100  -  (18  +  10)  =  72 
$1.50  ^  72  =  %2m  Answer. 

Whether  the  grocer  can  sell  at  this  price  may  be  question- 
able, but  he  has  the  satisfaction  of  knowing  the  truth  regarding 
profits. 

Limitations  of  Interpretation  by  Percentages. —  When  the 
data  to  be  compared  are  not  too  numerous  the  plan  of  expressing 
their  relationship  by  the  percentage  method  is  effective.     When, 


278 


ACCOUNTS  IN   THEORY  AND  PRACTICE 


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however,  the  data  consist  of 
much  detail  it  is  difficult  to  keep 
in  mind  a  sufficient  number  of  per- 
centages and  at  the  same  time 
relate  them  to  some  common  base. 
A  consideration  of  the  following 
proposition  will  make  this  clear. 
The  net  sales,  manufacturing,  sell- 
ing, and  general  expenses,  net  prof- 
its, and  dividends  declared,  and 
amounts  carried  to  surplus,  of  the 
Iron  Manufacturing  Company  for 
the  six  year  period  ending  De- 
cember 31,  1919,  are  as  shown 
herewith. 

The  percentages  shown  in  this 
table  are  based  on  the  sales  of  the 
year  shown  at  the  head  of  the 
column  in  which  they  appear.  As 
the  sales  differ  year  after  year 
the  value  of  the  percentages  for 
comparison  of  any  item  in  two 
or  more  years  is  nil.  See  page 
287,  for  a  graphic  chart  of  the 
same  data.  Percentages  are  value- 
less for  purposes  of  comparison 
unless  they  are  referable  to  a 
common  base. 

Turnover.  —  Rate  of  turnover 
refers  to  the  rapidity  of  the  sale 
of  merchandise.  If  on  an  aver- 
age a  business  sells  out  its  stock 
four  times  a  year  its  turnover  is 
said  to  be  four.  Expressed  in 
dollars  the  turnover  is  the  cost 
of  goods  sold.  Thus  if  the  in- 
come statement  shows  the  fol- 
lowing regarding  inventories  and 
purchases : 


RELATION  OF  ACCOUNTING  TO  MANAGEMENT        279 

Inventory  12/31/19 $6,000 

Purchases 20,000 

$26,000 
Less  Inventory  12/31/20 4,000 

Turnover $22,000 

then  assuming  that  the  average  stock  of  merchandise  is  ($6,000 
+  $4,000)  -^  2  or  $5,000,  the  rate  of  turnover  is  $22,000  h-  $5,000, 
or  4.4. 

Nothing  deserves  more  careful  attention  on  the  part  of  the 
manager  than  the  rate  of  turnover.  If  the  rate  of  turnover  is 
below  that  for  similar  concerns  being  run  on  an  efficient  basis 
then  either  sales  are  lagging  or  there  is  being  carried  an  excessive 
stock  of  merchandise.  This  same  principle  applies  also  to  manu- 
facturing. One  of  the  best  means  of  avoiding  the  tying  up 
of  capital  in  excessive  stocks  of  raw  materials  or  merchandise  is 
the  keeping  of  book  or  running  inventories.  A  large  part  of  the 
average  merchant's  capital  is  invested  in  merchandise.  Any- 
thing which  abridges  the  time  that  elapses  between  his  purchase 
and  his  sale  of  any  given  commodity  to  that  extent  reduces  the 
amount  of  capital  necessary  to  carry  the  required  quantity  of 
merchandise,  or  enables  the  merchant  with  a  given  amount  of 
capital  to  expand  his  activities  by  taking  on  additional  kinds  of 
goods. 

Some  business  men  hesitate  to  sell  anything  below  cost  and 
in  consequence  accumulate  quantities  of  stock  which  not  only 
grow  less  and  less  salable  as  time  passes  but  tie  up  a  quantity 
of  capital  from  which  no  return  is  secured.  If  capital  properly 
employed  is  worth  6  or  8  per  cent,  it  follows  that  holding  articles 
over  long  periods  of  time  is  disastrous  policy.  Not  only  do  the 
articles  become  less  salable  but  the  capital  invested  in  them 
does  not  circulate  and  thus  ceases  to  earn  a  return,  so  that  ulti- 
mately there  is  incurred  both  loss  of  capital  and  of  profit  which 
that  capital  should  normally  have  earned.  It  is  better  to  take  a 
partial  capital  loss,  if  necessary,  to  dispose  of  such  goods  quickly. 

Preparation  of  the  Budget. — The  purpose  of  the  budget  is  to 
enable  the  manager  to  make  an  intelligent  estimate  of,  and  to  pro- 
vide for,  the  customary  outlays  which  will  be  necessary  during 
the  coming  year.  In  a  well  thought  out  plan  the  budget  affords 
a  thoroughgoing  survey  of  future  requirements.     If  the  accounts 


280  ACCOUNTS  IN  THEORY  AND  PRACTICE 

have  been  well  kept  they  provide  a  storehouse  of  information 
which  the  manager  can  use  to  aid  in  constructing  a  budget,  mak- 
ing allowance  for  such  changes  from  the  past  program  as  may  be 
necessary.  Accounts  permit  the  study  of  expenditures  after 
they  are  made.  The  budget  permits  the  study  of  expenditures 
before  thay  are  made.  Scientific  budget-making  is  an  important 
step  in  the  direction  of  economy. 

Making  Contracts. — The  manager  can  make  contracts  for 
future  work  on  an  intelligent  basis  only  when  accurate  costs  of 
past  work  have  been  kept.  Moreover,  it  is  always  desirable  to 
know  what  is  the  outcome  of  any  undertaking.  This  cannot  be 
determined  by  estimation;  only  a  cost  system  adapted  to  the 
needs  of  the  business  will  serve.  It  is  necessary  to  compile  costs 
as  work  proceeds,  especially  when  the  contract  covers  an  exten- 
sive undertaking,  in  order  to  locate  waste  and  leaks,  and  to 
prevent  unnecessary  or  extravagant  expenditure.  Work  accom- 
plished is  compared  with  costs  incurred  in  order  to  keep  the  trend 
of  these  such  that  the  anticipated  profit  will  result  when  the  work 
is  finished. 

Reports  on  Internal  Affairs — ^Manufacturing. — These  reports 
should  take  the  form  of  prompt  periodical  analyses  covering: 

1.  Wastes  which  occur  daily,  also  with  reference  to  any  given  lot  or  order 
manufactured. 

2.  Operating  costs,  daily  in  relation  to  orders. 

3.  Complete  cost  of  orders  finished,  either  daily  or  weekly. 

4.  Production  accomplished  by  the  day,  run,  or  week,  according  to  nature 
of  the  work. 

5.  Payroll,  according  to  time  of  payment  of  wages. 

6.  Special  and  general  expenses.  , 


CHAPTER  XLI 
GRAPHIC  CHARTS 

Use  of  Graphs. — Statistical  data  may  sometimes  be  interpreted 
to  advantage  by  the  use  of  graphic  charts.  Graphs  serve  to 
emphasize  tendencies  and  relationships  and  to  make  them  more 
vivid  than  do  tables  of  figures.  Statistical  tables  are  sometimes 
so  detailed  and  so  complicated  that  only  the  most  experienced 
can  interpret  them  adequately.  Important  tendencies  are  apt 
to  be  overlooked.  We  have  found  that  expression  by  percentages 
sometimes  is  preferable  to  expression  in  quantities  of  dollars 
and  cents;  this  is  especially  true  when  all  items  to  be  considered 
are  referable  to  a  common  base.  When,  however,  there  are  two 
variables  instead  of  one  it  becomes  necessary  to  contrive  some 
other  means  of  conveying  an  idea  of  the  significance  of  their 
constantly  varying  relationship  to  each  other.  Thus  we  fre- 
quently find  that  we  must  interpret  numerous  quantities  relat- 
ing to  successive  periods  of  time.  We  desire  to  show  their 
relative  weight  and  tendencies.  Graphs  are  especially  suited  to 
this  purpose. 

Fundamentals  of  Graphic  Presentation. — Graphs  are  generally 
employed  to  indicate  the  relationship  existing  between  sets  of 
data.  One  set  of  data  usually  refers  to  an  independent  variable 
and  the  other  set  of  data  to  a  dependent  variable.  The  depend- 
ent variable  is  to  be  interpreted  in  terms  of  the  independent 
variable.  Thus  we  say  that  food  prices  have  risen  100  per  cent 
over  a  period  of  five  years.  The  price  of  food  is  the  dependent 
variable  and  time  is  the  independent  variable. 

In  interpreting  accounting  data  time  is  usually  the  independent 
variable,  because  most  important  tendencies  of  a  financial  char- 
acter are  measured  in  terms  of  days,  weeks,  months,  or  years. 
For  example,  we  say  that  in  one  year  net  profits  amount  to  5% 
on  invested  capital  and  in  the  next  year  to  6%.  Here  the  de- 
pendent variable  is  the  rate  of  net  profit  on  invested  capital  and 
time,  expressed  in  years,  the  independent  variable. 

Principles  of  Graph  Construction. — For  a  detailed  discussion 
of  graphic  presentation  the  student  is  referred  to  works  treating 

281 


282  ACCOUNTS  IN   THEORY  AND  PRACTICE 

of  that  subject.'  It  will  be  possible  here  merely  to  state  the  more 
general  rules  which  must  be  followed.  Presumably,  the  student 
is  familiar  with  the  common  coordinate  paper  used  by  statis- 
ticians and  chartographers.  An  examination  of  the  charts  shown 
in  this  chapter  will  indicate  its  nature.  In  general,  this  paper 
must  be  ruled  to  a  scale  which  careful  planning  shows  to  be  best 
suited  for  the  presentation  of  the  data  to  be  charted.  If  the 
scale  is  unnecessarily  small  it  will  tend  to  obscure  the  curve. 
The  following  rules  may  be  studied  with  reference  to  the  charts 
which  follow  :2 

1.  The  general  arrangement  of  a  diagram  should  proceed  from 
left  to  right,  i.e.,  so  that  it  can  be  read  from  left  to  right. 

2.  Where  possible  represent  qualities  by  hnear  magnitudes  as 
areas  or  volumes  are  more  likely ^to  be  misinterpreted.  Areas 
and  volumes  are  not  used  in  this  chapter. 

3.  For  a  curve  the  vertical  scale,  whenever  practicable,  should 
be  so  selected  that  the  zero  line  will  appear  on  the  diagram. 

4.  The  zero  lines  of  the  scales  for  a  curve  should  be  sharply 
distinguished  from  the  other  coordinate  lines. 

5.  It  is  advisable  not  to  show  any  more  coordinate  lines  than 
necesary  to  guide  the  eye  in  reading  the  diagram. 

6.  The  curve  lines  of  a  diagram  should  be  sharply  distinguished 
from  the  ruling. 

7.  The  horizontal  scale  for  curves  should  usually  read  from 
left  to  right  and  the  vertical  scale  from  bottom  to  top. 

8.  Figures  for  the  scales  of  a  diagram  should  be  placed  at  the 
left  and  at  the  bottom. 

9.  It  is  often  desirable  to  include  in  the  diagram  the  numerical 
data  presented. 

10.  If  numerical  data  are  not  included  in  the  diagram  it  is 
desirable  to  give  the  data  in  tabular  form  accompanying  the 
diagram. 

11.  All  lettering  and  all  figures  on  a  diagram  should  be  placed 
so  as  to  be  easily  read  from  the  base  as  the  bottom,  or  from  the 
right-hand  edge  of  the  diagram  as  the  bottom. 

12.  The  title  of  a  diagram  should  be  made  as  clear  and  com- 

*  See  Brinton,  W.  C. :  Graphic  Methods  for  Presenting  Facts;  also  Warne, 
F.  J. :  Chartography  in  Ten  Lessons. 

'Adapted  from  report  of  Joint  Committee  on  Standards  for  Chraphic  Pres- 
entation. Copies  may  be  had  from  The  American  Society  of  Mechanical 
Engineers,  29  West  39th  St.,  New  York:  Price  10  cents. 


GRAPHIC  CHARTS  283 

plete  as  possible.     Sub-titles  or  descriptions  should  be  added 
if  necessary  to  insure  clearness. 

Data  for  Graphic  Presentation. — ^The  following  are  suggestions 
as  to  accounting  data  which  afford  subject  matter  for  graphic 
presentation : 

1.  Comparative  sales,  for  two  or  more  years,  by  months,  also 
cumulative  totals  of  sales  by  months. 

2.  The  same  by  years. 

3.  Sales,  cost  of  sales  and  expenses,  and  net  profits  by  months. 

4.  Purchases  and  sales  by  months. 

5.  Significant  trial  balance  items,  by  months. 

6.  Undistributed  indirect  and  total  indirect,  by  months. 

7.  Departmental  sales,  purchases,  profits,  wages,  etc.,  by 
months. 

8.  Advertising  expenses  and  sales,  by  months. 

9.  Raw  materials  purchased,  raw  materials  on  hand,  goods  in 
process,  finished  goods,  and  orders  received,  by  months. 

10.  Net  profits,  dividends,  and  amount  carried  to  surplus,  by 
years. 

The  charts  which  follow  should  be  studied  with  reference  both 
to  the  data  presented,  the  significance  of  the  relations  expressed, 
and  the  plan  and  arrangement  of  the  diagrams.' 

Following  are  four  diagrams  presented  here  to  illustrate  the 
method  and  possibilities  of  graphic  interpretation  of  accounting 
data.  Plate  I  shows  the  trend  of  monthly  sales  of  a  department 
for  two  successive  years.  This  brings  before  the  mind  more 
clearly  and  more  definitely  the  relative  volume  and  tendency 
of  sales  during  the  two  years  than  a  table  of  statistics  would  be 
likely  to  do.  For  example,  the  fluctuations  were  somewhat  more 
marked  in  1918  than  in  1919.  Sales  in  1919  are  greater  than  in 
1918  with  the  exception  of  one  month,  April,  which  shows  a 
remarkable  increase  in  sales,  in  1918.  Are  the  tendencies  such 
as  would  be  likely  to  occur  in  a  general  merchandise  business? 
For  instance,  would  sales  be  likely  to  fall  from  a  high  mark  in 
December  to  a  low  mark  in  January? 

Plate  II  shows  the  trend  of  sales  and  purchases  during  a  given 
year.  Note  that  in  October  the  purchases  are  nearly  as  great  as 
the  sales,  and  that  in  the  succeeding  months  there  is  a  falling  off 
in  purchases.     Such  a  diagram  might  serve  to  bring  before  the 

*  For  the  use  of  graphs  in  studying  depreciation  methods  see  Satiers: 
Principles  of  Depreci(Uion,  chapters  XI-XV. 


284 


ACCOUNTS  IN  THEORY  AND  PRACTICE 


manager  the  fact  that  overbuying  exists.  Of  course  he  might 
learn  this  from  other  sources,  but  in  no  other  way  could  it  be  pre- 
sented so  emphatically  and  so  simply.  Naturally  every  graphic 
illustration  must  be  read  with  reference  to  actual  conditions. 
What  is  overbuying  in  one  business,  or  under  given  circum- 
stances, might  not  be  overbuying  under  other  conditions.  Pur- 
chases are  made  in  advance  for  the  rush  seasons  in  some  lines 
of  business.  Graphs  will  serve  to  emphasize  this  relationship 
between  purchases  and  sales. 


50 
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12 


Plate  I. — Monthly  sales  of  department  B  for  the  years  1918  and   1919,  in 
thousands  of  dollars. 


Plate  III  shows  the  status  of  the  indirect  costs  of  manufacture 
in  Department  A  of  the  Falls  Manufacturing  Company,  for  the 
year  1919.  Note  the  progressive  relationship  existing  between 
distributed  and  undistributed  indirect.  It  is  the  desire  of  the 
manager  to  reduce  undistributed  indirect  to  the  lowest  possible 
minimum  because  it  is  the  result  of  idle  machine  time.  Why 
does  not  total  indirect  increase  as  rapidly  as  distributed  indirect, 
after  the  low  point  in  May?  What  would  be  the  operating  con- 
dition if  the  curve  for  undistributed  indirect  reached  that  for 


GRAPHIC  CHARTS 


285 


total  indirect?     If  it  reached  the  zero  line?     What  would  then  be 
the  position  of  the  curve  for  distributed  indirect? 

Plate  IV  shows  in  graphic  form  the  information  given  in  the 
table  on  page  278.  Although  there  are  a  large  number  of  curves, 
this  method  is  a  distinct  aid  in  bringing  the  situation  clearly 
before  the  mind.  Certain  interesting  relations  and  tendencies 
are  brought  out.  Note  that  when  production  declines,  net  sales 
and  net  profits  decline  still  more  rapidly.     The  dividend  rate 


85 

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7 
Months 


10 


11 


12 


Plate  II. — Monthly  purchases,  S.  T.  Ailing,  for  the  year  1919. 

remains  constant.  General  expenses  increase  but  slightly  with 
increasing  business.  The  same  is  true  of  selling  expenses.  Note 
that  in  the  years  in  which  a  deficit  occurred  the  curve  showing 
the  amount  carried  to  surplus  falls  before  the  zero  line.  As  sales 
increase  net  profits  increase  still  more  rapidly. 

BIBLIOGRAPHY 
Part  VI.     Special  Applications  of  Principles 
Manufacturing  Accounting : 

Chcrch,  a.  H.     The  Proper  Distribution  of  Expense  Burden.     New  York, 
1912. 


286 


ACCOUNTS  IN  THEORY  AND  PRACTICE 


Church,  A.  H.     Production  Factors.     New  York,  4910. 

Church,  A.  H.     Manufacturing  Costs  and  Accounts.     New  York,  1917. 

Clark,   E.   S.     Practical  Costs.     In  Industrial  Management,  Dec,   1916 

and  following  numbers. 
Cole,  W.  M.     Accounts:  Their  Construction  and  Interpretation.     Boston, 

1915.     Chapter  XIX. 
Dickinson,  A.  L.     Accounting  Practice  and  Procedure.     New  York,  1913. 

Chapter  IX. 
Evans,  H.  A.     Cost  Keeping  and  Scientific  Management.     New  York,  1911. 
Garcke,  E.  and  Fells,  J.  M.     Factory  Accounts.     London,  1911. 
Going,  C.  B.     Principles  of  Industrial  Engineering.     New  York,  1911. 


100 


90 


80 


70 


60 


^50 


40 


30 


20 


10 


^^ 

• — 

.-€> 

- 

^ 

~'    ~~ 

y^ 

___ 

-^ 

^ 

Tota^^ 

^ 

y 

— ' 

■^ 

^ 

\ 

#1 



/ 

N 

^ 

A 

/ 

y 

/' 

/ 

s  'in 

K 

y 

/ 

•..•^ 



^il^jn 

ct 

-" — 

y 

123456  789  10         11  12 

Months 

Plate  III. — Total  indirect,  distributed  indirect  and  undistributed  indirect  for 
department  A,  Falls  Manufacturing  Company,  in  the  year  1919. 


Hatfield,  H.  R.     Modern  Accounting.     New  York,  1909.     Chapter  XVI. 
Klein,    J.    J.     Elements    of    Accounting.     New    York,    1913.     Chapters 

XIII  and  XIV. 
Lewis,  E.  St.  Elmo.     Efficient  Cost  Keeping.     Detroit,  1914. 
Moxey,  E.  p.,  Jr.     Principles  of  Factory  Cost  Keeping.     New  York,  1913. 
Nicholson,  J.  L.     Cost  Accounting,  Theory  and  Practice.     New  York, 

1918. 
Scovell,  C.  H.     Cost  Accounting  and  Burden  Application.     New  York, 

1916. 
Webner,  F.  E.     Factory  Costs.     New  York,  1911. 


GRAPHIC  CHARTS 


287 


WiLDMAN,  J.  R.     Principles  of  Cost  Accounting.     New  York,  1911. 
Woods,  C.  H.     Accounting  Methods  for  Industrials.     New  York,  1917. 

Management : 

Church,  A.  H.     The  Science  and  Practice  of  Management.     New  York, 

1911. 
Ennis,  W.  D.     Works  Management.     New  York,  1911. 
Franklin,  B.     Cost  Reports  for  Executives. 


48 


24 


? [    ^_ ^h 


CosttoMtfJ, 


Dividends  Declared 


Sellinc 


Expeni 


/ 


^ 


General  Expense 


ansa  |  /     ___ 

"Iz 


i,\*^ 


J^-^7 


1914 


1S15^\ 
Years" 


1916 


1918 


1919 


0*i 


Plate  IV. — Comparative  income  statement,  the  Iron  Manufacturing  Company, 
for  the  six  year  period  ending  Dec.  31,  J919.     See  table  page  278. 

Graphic  Charts : 

Brinton,  W.  C.     Graphic  Methods  for  Representing  Facts.     New  York, 

1914. 
Secrist,  Horace.     Business  Statistics.     New  York,  1920. 
Warne,  F.  J.     Chartography  in  Ten  Lessons.     Washington,  1919. 

Department  Accounting: 

MoxEY,  E.  P.  and  others.     Practical  Accounting  Methods.     New  York, 
1913. 


APPENDIX  A 
REVIEW  QUESTIONS 

Chapter  I 

1.  Show  why  accounting  is  a  branch  of  economic  science. 

2.  Why  do  modern  industrial  methods  require  carefully  compiled  records? 

3.  How  are  price-making  and  competition  related  to  accounts? 

4.  How  do  adequate  records  improve  credit  conditions? 

6.  In  what  way  is  efficient  management  related  to  accounting? 

6.  What  information  do  accounts  afford  in  valuations? 

7.  How  is  income  taxation  dependent  on  accounts? 

8.  Why  should  an  investor  understand  accounting? 

9.  How  does  correct  determination  of  profits  affect  the  interests  of  various 
claimants? 

Chapter  11 

1.  Distinguish  between  cash  and  credit  transactions. 

2.  How  are  cash  and  credit  transactions  recorded? 

3.  What  is  the  function  of  the  Journal? 

4.  Explain  the  technical  use  of  the  words,  debit  and  credit. 

5.  Give  three  rules  for  debits. 

6.  Give  three  rules  for  credits. 

7.  Distinguish  between  losses  and  expenses. 

Chapter  III 

1.  How  should  the  journal  be  subdivided?     Why? 

2.  What  is  the  function  of  the  Cash  Journal? 

3.  Why  are  losses  or  gains  not  shown  for  each  sale? 

4.  What  is  a  chronological  record? 

5.  What  is  an  "account?" 

6.  What  is  the  function  of  the  Ledger? 

7.  Distinguish  between  "real"  and  "nominal"  accounts. 

8.  What  are  "mixed"  accounts? 

9.  Explain  the  difference  between  chronological  and  functional  records. 

10.  Define  "posting." 

11.  What  is  the  "folio"  column? 

Chapter  IV 

1.  What  is  meant  by  the  interpretation  of  accounts? 

2.  How  do  losses  and  gains  affect  liabilities  and  assets? 

3.  Define  "capital. " 

4.  What  statement  should  be  made  up  preliminary  to  opening  a  set  of 
books? 

5.  What  is  the  purpose  of  the  opening  journal  entry? 

288 


APPENDIX  289 

6.  Suggest  how  the  ledger  accounts  may  be  arranged  and  classified. 

7.  How  should  cash  be  treated  in  the  opening  entry? 

8.  What  is  meant  by  the  analysis  of  an  account? 

9.  To  what  extent  should  accounts  be  subdivided? 

Chapter  V 

1.  Distinguish  between  the  functions  of  the  Cash  Journal  and  the  Gen- 
eral Journal. 

2.  What  is  the  purpose  of  the  purchases  account?  The  sales  account? 
The  capital  account?  The  nomrnal  accounts'?  The  accounts  payable? 
The  accounts  receivable? 

Chapter  VI 

1.  What  is  a  trial  balance? 

2.  Show  why  the  trial  balance  is  reall}'^  a  trial  balance  of  balances. 

3.  What  are  the  two  principal  objects  of  a  trial  balance? 

4.  Explain  the  character  of  purchases  and  inventory  accounts  in  the  trial 
balance. 

6.  What  is  the  purpose  of  the  closing  entries? 

6.  Why  are  the  nominal  accounts  closed? 

7.  What  is  the  purpose  of  the  profit  and  loss  account? 

8.  Why  is  net  profit  carried  to  capital? 

9.  How  does  the  final  trial  balance  differ  from  the  first  trial  balance? 
From  the  balance  sheet? 

10.  How  does  the  profit  and  loss  account  differ  from  the  profit  and  loss 
statement? 

11.  What  are  the  six  steps  in  the  process  of  ledger  interpretation? 

12.  What  is  the  relation  of  the  balance  sheet  and  the  profit  and  loss 
statement?     Why  is  their  value  largely  comparative? 

13.  What  is  the  accounting  period? 

Chapter  VII 

1.  What  is  the  purpose  of  practice  work? 

2.  What  materials  are  required  for  this  chapter? 

3.  What  is  a  diary  of  events? 

4.  Why  not  charge  furniture  bought  to  "Purchases?" 
6.  What  is  a  "stereotyped  phrase?" 

6.  What  is  the  purpose  of  the  notes  receivable  account? 

7.  When,  in  practice,  is  posting  done? 

8.  In  closing,  what  becomes  of  the  balance  in  the  withdrawals  account? 

9.  Why  is  discount  on  purchases  a  credit  nominal  account? 
10.  Distinguish  between  the  "new"  and  "old"  inventories. 

Chapter  VIII 

1.  WTiy  is  "mortgage"  a  real  account? 

2.  Why  is  "bad  debts"  a  nominal  account? 

3.  Why  does  not  the  new  inventory  appear  in  the  trial  balance? 

4.  Distinguish  between  interest  and  interest  accrued. 

19 


290  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Chapter  IX 

1.  What  is  an  accrual?     A  deferred  charge? 

2.  Define  interest.     How  may  interest  periods  differ  from  accounting 
periods? 

3.  Explain  the  use  of  the  interest  accrued  account. 

4.  When  is  the  interest  accrued  account  closed?     When  is  the  interest 
account  closed? 

6.  How  does  the  principle  of  accruals  apply  to  wages  and  salaries?     To 
taxes? 

6.  What  is  a  deferred  charge?     Give  an  illustration  not  found  in  the  text? 

7.  Are  buildings  and  machinery  deferred  charges?     Why? 

Chapter  X 

I.  When  is  advertising  a  deferred  charge? 
•2,  What  are  adjustment  entries? 

8.  When  are  adjustments  for  wages  accrued  required? 

Chapter  XI 

1.  State  three  causes  of  depreciation. 

2.  How  does  capital  in  the  economic  sense  differ  from  capital  in  the 
accounting  sense? 

3.  Distinguish  between  fixed  and  working  capital. 

4.  How  may  depreciation  cause  financial  trouble? 
6.  Why  does  it  sometimes  cause  bankruptcy? 

6.  How  may  depreciation  be  counteracted? 

7.  What  is  a  valuation  reserve? 

8.  How  may  depreciation  be  charged  without  using  a  valuation  reserve 
account? 

9.  Should  the  reserve  be  kept  in  cash?     Explain. 

10.  Why  is  the  depreciation  reserve  a  clearing  account? 

II.  What  is  normal  depreciation?     How  is  it  related  to  efficiency? 
12.  Explain  the  use  of  valuation  reserves  for  bad  debts. 

Chapter  XII 

1.  What  would  an  increase  in  the  reserve  for  bad  debts  from  year  to  year 
indicate,  providing  business  is  not  growing? 

2.  Why  is  depreciation  an  expense? 

3.  Why  is  the  depreciation  reserve  called  a  valuation  account? 

4.  Why  should  depreciation  reserves  be  deducted  from  corresponding 
assets  in  the  balance  sheet? 

6.  Why  is  the  year  ordinarily  too  long  as  an  accounting  period? 
6.  Why  cannot  bad  debts  be  credited  directly  to  the  accounts  receivable 
accounts? 

Chapter  XIII 

1.  When  is  the  partnership  form  of  organization  desirable? 

2.  What  is  a  personal  service  corporation? 


APPENDIX  291 

3.  What  are  the  leading  features  of  common  law  partnerships? 

4.  How  may  limited  partnerships  be  established? 

5.  May  all  partners  be  limited  as  to  liability? 

6.  How  does  the  English  Partnership  Act  of  1890  define  a  partnership? 
The  New  York  law? 

7.  What  provisions  should  appear  in  the  articles  of  agreement? 

8.  What  causes  lead  to  partnership  dissolution? 

9.  How  are  assets  distributed  at  dissolution? 

Chapter  XIV 

1.  How  does  accounting  for  partnerships  differ  from  accounting  for  a 
sole  proprietor? 

2.  When  is  goodwill  brought  in  to  adjust  partners'  capital  accounts? 

3.  How  does  the  interest  question  arise  in  partnership  accounting? 

4.  Why  distribute  interest  on  investments  when  profits  are  distributed  in 
proportion  to  investments? 

6.  What  is  meant  by  the  average  investment  for  a  given  period?     How  is 
it  found? 

6.  In  closing,  how  are  the  partners'  withdrawals  accounts  treated? 

7.  How  is  a  deficit  treated  when  a  partnership  is  liquidated? 

8.  No  provision  to  the  contrary,  how  are  profits  divided  among  partners? 

Chapter  XV 

1.  Give  reason  why  Gray  and  Smith  credit  their  capital  accounts  with  5 
per  cent  on  their  investments? 

2.  Why  are  not  withdrawals  carried  to  profit  and  loss? 

Chapter  XVI 

1.  What  changes  in  the  system  of  accounts  does  expanding  business 
necessitate? 

2.  What  is  the  purpose  of  controlling  accounts  and  subordinate  ledgers? 

3.  When  are  special  journals  needed? 

4.  What  is  the  purpose  of  special  columns  in  journals? 

6.  When  are  postings  to  the  controlling  accounts  ordinarily  made?     Why? 

6.  How  do  controlling  accounts  facilitate  the  work  of  finding  errors? 

7.  How  should  returned  sales  and  returned  purchases  be  treated? 

Chapter  XVII 

1.  What  is  the  purpose  of  a  bank  account? 

2.  Why  should  all  cash  receipts  be  deposited  in  bank? 

8.  Describe  the  imprest  system  of  handling  petty  cash. 
4.  When  is  petty  cash  account  charged  in  the  ledger? 
6.  What  advantages  has  the  imprest  sj'stem? 

Chapter  XVIII 

1.  Name  the  books  ordinarily  required  in  a  system  of  accounts  for  a  trad- 
ing concern  with  numerous  accounts  payable  and  receivable. 

2.  What  is  the  significance  of  a  "Salaries  Prepaid"  account? 


292  ACCOUNTS  IN   THEORY  AND  PRACTICE 

3.  When  the  petty  cash  is  replenished  what  accounts  are  charged? 

4.  How  distinguish  between  items  to  be  paid  from  petty  cash  and  by 
check? 

6.  Why  cannot  a  purchase  of  furniture  be  entered  in  the  purchases  jour- 
nal?    How  might  this  be  remedied? 

7.  What  is  meant  by  accrued  interest? 

Chapter  XIX 

1.  What  is  the  purpose  of  the  voucher  register? 

2.  What  is  a  voucher  system? 

3.  What  is  a  voucher? 

4.  Explain  use  of  paid  and  unpaid  vouchers'  files? 

6.  What  charges  are  made  through  the  voucher  register? 

Chapter  XX 

1.  What  books  does  the  voucher  register  displace? 

2.  How  are  discounts  on  purchases  taken  care  of  in  the  voucher  system? 

3.  What  columns  should  a  voucher  register  contain? 

4.  How  should  vouchers  be  numbered?     Why? 

6.  Why  are  adjustments  and  closing  entries  made  in  the  general  journal? 

Chapter  XXI 

1.  When  is  a  private  ledger  desirable? 

2.  What  is  the  function  of  the  private  journal? 

3.  What  accounts  are  ordinarily  kept  in  the  private  ledger? 

Chapter  XXII 

1.  How  is  the  private  ledger  related  to  the  general  ledger? 

2.  What  transactions  require  entries  in  the  private  ledger? 

3.  Is  it  usually  desirable  to  open  the  profit  and  loss  account  in  the  private 
ledger?     Why? 

Chapter  XXIII 

1.  When  does  the  corporate  form  of  organization  become  desirable? 

2.  How  are  corporate  policies  determined? 

3.  What  is  meant  by  limited  liability?     Double  liability? 

4.  What  principle  determines  the  desirable  ratio  of  stocks  to  bonds? 
6.  What  is  the  status  of  a  stockholder  in  a  corporation? 

6.  How  is  ownership  in  a  company  transferred? 

7.  What  is  cumulative  preferred  stock  ? 

8.  What  is  the  deed  of  trust? 

9.  What  is  stock  full  paid? 

Chapter  XXIV 

1.  Should  unissued  stock  be  shown  in  the  opening  entry?     Why? 

2.  What  accounting  procedure  is  necessary  when  subscriptions  are  paid 
in  instalments? 

3.  What  may  be  received  in  payment  of  subscriptions? 

4.  What  explanations  are  desirable  in  the  opening  entry? 


APPENDIX  293 

Chapter  XXV 

1.  How  does  the  valuation  question  arise  when  a  proprietorship  or  a 
partnership  is  incorporated? 

2.  Should  goodwill  ever  be  capitaUzed?     Why? 

3.  What  factors  determine  the  desirable  amount  of  authorized  capital 
stock  ? 

4.  Describe  the  process  of  conversion  to  the  corporate  form  (a)  when  the 
old  books  are  continued;  (6)  when  new  books  are  opened. 

Chapter  XXVI 

1.  What  is  the  deed  of  trust? 

2.  What  factors  determine  the  interest  rate  of  bonds? 

3.  Describe  the  accounting  procedure  (o)  when  bonds  are  sold  at  par; 
{h)  when  sold  above  or  below  par. 

4.  What  is  meant  by  the  effective  interest  rate? 

5.  How  is  the  effective  interest  rate  determined? 

6.  When  and  how  should  interest  charges  be  recorded? 

7.  When  is  the  interest  accrued  account  closed? 

8.  What  is  the  relation  of  the  premium  or  discount  on  bonds  to  current 
profit  and  loss? 

Chapter  XXVH 

W  What  are  bonds  issued  in  perpetuity? 

2.  What  are  the  two  sources  of  funds  for  redemption  of  bonds? 

3.  How  may  the  question  of  bond  redemption  be  related  to  depreciation? 

4.  What  is  a  sinking  fund?     A  sinking  fund  trustee? 

5.  Why  should  not  interest  on  bonds  be  paid  out  of  capital? 

6.  What  should  be  done  with  interest  earned  by  the  sinking  fund? 

Chapter  XXVIII 

1.  Why  is  a  surplus  or  deficit  account  required  in  corporation  accounting? 

2.  Who  determines  the  disposition  of  the  surplus? 

3.  For  what  objects  are  special  reservations  of  surplus  made? 

4.  What  is  meant  by  a  conservative  dividend  policy? 
6.  Describe  several  kinds  of  dividends. 

6.  What  is  a  declaration  of  dividends? 

7.  What  is  the  accounting  procedure  when  dividends  are  declared? 
When  they  are  paid? 

8.  Describe  five  books  peculiar  to  corporations. 

Chapter  XXIX 

1.  Wliat  are  pro  forma  journal  entries? 

2.  What  is  the  relation  of  premium  on  bonds  to  interest? 

3.  What  is  the  purpose  of  a  sinking  fund  reserve? 

4.  What  is  the  relation  of  discount  on  bonds  to  interest? 


294  ACCOUNTS  IN  THEORY  AND  PRACTICE 

Chapter  XXX 

1.  How  is  the  income  account  frequently  subdivided? 

2.  What  are  the  advantages  of  such  subdivision? 

3.  How  may  discount  on  purchases  be  treated  in  the  income  account? 

4.  How  does  a  statement  differ  from  an  account? 

6.  Why  is  the  statement  form  usually  preferable  to  the  account  form  in 
published  reports? 

6.  Why  is  "net  sales"  an  important  statistical  base? 

7.  How  can  the  income  statement  be  studied  with  reference  to  the 
assets? 

8.  What  are  some  of  the  most  important  items  in  the  income  statement 
that  deserve  study? 

9.  What  is  the  relationship  between  fixed  charges  and  the  margin  of 
profits? 

10.  How  does  uniformity  in  income  vary  in  different  kinds  of  enterprises? 

11.  How  is  the  preceding  question  related  to  the  question  of  reserving 
profits  in  the  form  of  surplus? 

12.  \Miat  portion  of  its  funds  may  a  concern  safely  secure  by  selling 
bonds? 

Chapter  XXXI 

1.  What  is  a  comparative  income  statement?     How  should  increases 
and  decreases  as  between  years  be  expressed? 

2.  How   does   Hooper  suggest  that   an  income  statement  should  be 
studied? 

3.  By  what  governmental  body  are  railroad  accounts  prescribed? 

4.  What  is  the  significance  of  the  operating  ratio? 

6.  What  is  meant  by  "other  income"  in  railroad  accounting? 

6.  Why  is  "renewals"  a  charge  to  income? 

7.  How  did  the  Delaware,  Lackawanna  &  W^estern  charge  off  discount  on 
bonds?     WTiy  is  this  unusual? 

8.  What  is  remarkable  about  the  funded  debt  of  the  D.  L.  &  W.? 

9.  How  may  the  income  statement  of  the  U.  S.  Steel  Corporation  be 
criticized? 

10.  How  did  the  years  1914  and  1915  compare  in  prosperity  for  this  com- 
pany? 

Chapter  XXXII 

1.  Why  are  the  balance  sheet  and  the  income  statement  complementary 
business  documents? 

2.  Describe  three  possible  forms  of  the  balance  sheet. 

3.  How  should  assets  be  arranged  in  the  balance  sheet? 

4.  How  does  A.  Lowes  Dickinson  classify  invested  capital? 
6.  How  do  working  and  current  assets  differ? 

6.  Why  separate  working  and   current  assets  in  the  balance  sheet? 
W^ould  this  separation  be  always  desirable? 

7.  What  two  interpretations  apply  to  deferred  charges? 

8.  Are  expenses  paid  in  advance  working  assets? 

9.  How  does  surplus  differ  from  capital  stock? 


APPENDIX  295 

10.  How  is  liability  on  capital  stock  limited? 

11.  What  is  the  trust  fund  theory  of  capital  stock? 

12.  What  is  the  meaning  of  "wasting  assets?" 

13.  Does  the  usual  rule  of  preservation  of  capital  applj'  in  case  of  wasting 
assets? 

14.  How,  in  such  a  case,  are  the  bondholders  protected? 

16.  What  objection  may  be  raised  against  the  use  of  a  sinking  fund  for 
this  purpose? 

16.  How  may  capital  stock  be  reduced  in  Connecticut? 

Chapter  XXXHI 

1.  What  does  a  reasonable  interpretation  of  the  trust  fund  theory  require 
for  protection  of  bondholders? 

2.  When  is  it  permissible  to  pay  dividends  from  capital? 

3.  Should  all  profits  be  subject  to  dividend  distribution? 

4.  Why,  in  determining  profits  subject  to  distribution,  is  not  each  year  a 
unit? 

5.  What  is  meant  by  "integrity  of  invested  capital?" 

6.  When  does  a  profit  result  from  appreciation  of  property? 

7.  What  is  the  nature  of  a  premium  on  capital  stock? 

Chapter  XXXIV 

1.  How  do  accounts  locate  responsibilitj-? 

2.  WTiat  are  the  objects  to  be  secured  by  departmentalization? 

3.  What  rules  should  govern  in  fixing  the  number  of  the  departments? 

4.  How  are  clearing  accounts  used  in  department  accounting? 

6.  On  what  basis  should  heat,  rent,  and  advertising  be  distributed  to 
departments? 

Chapter  XXXV 

1.  Why,  in  department  accounting,  is  it  necessary  to  take  careful  account 
of  space  occupied  by  each  department? 

2.  Wliat  accounts  should  be  kept  for  each  department?     What  ones 
should  be  general  clearing  accounts? 

3.  In  general,  what  rules  govern  in  determining  the  necessary  columns  in 
the  voucher  register,  sales  journal,  etc.? 

4.  Why  must  inventories  be  kept  by  departments? 

6.  WTiat  statements  should  be  declared,  at  closing,  for  a  department 
store? 

6.  What  is  the  purpose  of  the  trading  section?     The  administrative 
section? 

7.  WTiy  is  not  a  balance  sheet  prepared  for  each  department? 

Chapter  XXXVI 

1.  How  should  space  rented  be  accounted  for? 

2.  Suggest  another  base  than  candle  power  for  distribution  of  light 
expense. 


296  ACCOUNTS  IN   THEORY  AND  PRACTICE 

Chapter  XXXVII 

1.  What  is  the  meaning  of  "cost,"  in  trade,  in  manufacture? 

2.  When  is  finished  product  for  one  concern  raw  material  for  another? 

3.  What  is  meant  by  "indirect  costs?" 

4.  How  does  manufacturing  accounting  differ  from  trading  accounting? 

5.  Describe  the  procedure  when  materials  are  purchased. 

6.  What  is  a  manufacturing  order? 

7.  What  is  a  production  order?     Plant  order? 

8.  What  is  the  purpose  of  a  cost  ledger?     By  what  account  is  it  con- 
trolled? 

9.  What  are  the  chief  sources  of  indirect  costs? 

10.  Why  are  not  certain  general  and  administrative  expenses  charged  to 
manufacture? 

11.  What  is  the  direct  labor  basis  of  expense  distribution?     The  raw 
materials  method?     The  prime  cost  method? 

Chapter  XXXVIII 

1.  What  is  the  old  machine  rate?     The  new  machine  rate? 

2.  Describe  two  methods  of  accounting  for  idle  time  costs. 

3.  How  does  the  secondary  supplementary  rate  differ  from  the  first 
supplementary  rate? 

4.  What  does  Scovell  advocate  doing  with  idle  time  cost?     Why? 
6.  Give  four  advantages  of  a  cost  system. 

Chapter  XXXIX 

1.  Why  are  three  inventory  accounts  required  in  manufacturing  ac- 
counting? 

2.  Why  should  drawings  and  models  usually  be  depreciated  rapidly? 

3.  In  general,  what  determines  the  value  of  a  share  of  stock? 

4.  Why  is  depreciation  an  important  factor  in  the  determination  of  stock 
values? 

Chapter  XL 

1.  What  information  does  the  manager  need?     Where  does  he  secure  it? 

2.  In  what  form  should  reports  to  the  manager  be  written? 

3.  How  is  expression  by  percentages  useful?     What  are  its  limitations? 

4.  Why  should  profits  be  reckoned  on  the  selling  price? 

5.  What  is  turnover?     How  does  rate  of  turnover  serve  as  an  index  of 
efficiency? 

6.  What  is  a  budget?    How  is  it  related  to  the  accounts? 

7.  How  does  a  knowledge  of  costs  aid  in  making  contracts? 

8.  In  reporting  to  the  manager  on  internal  conditions,  what  points  should 
be  covered? 

Chapter  XLI 

1.  Why  are  graphs  sometimes  used  to  interpret  statistics? 

2.  In   graphics,    what   is   the   independent   variable?     The   dependent 
variable? 

3.  What  should  be  the  general  arrangement  of  the  diagram? 

4.  Suggest  kinds  of  data  which  submit  to  graphic  presentation. 


INDEX 


"Account;"  defined,  16 

Accounting;  function  of,  22:  relation 
to  management,  Ch.  XL. 

Accounting  period;  defined,  43 

Accounts;  a  branch  of  economics,  1; 
and  credit  system,  4;  and 
management,  4;  arrangement  in 
ledger,  25,  27;  as  aid  in  compe- 
tition, 3;  as  aid  in  price  making, 
3;  functional  classification  of, 
17;  interpretation  of,  22;  ledger, 
Intel  pretation  of,  Ch.  VI; 
mixed,  defined,  19;  nominal,  de- 
fined, 18;  real,  defined,  18;  re- 
lation to  investing  5;  relation 
to  profit.  6:  relation  to  taxation, 
5;  relation  to  valuation,  5; 
subdivision  of,  28;  two  classes 
of,  18,  23 

Accruals;  practice  work^  Ch.  X; 
theory  of,  Ch.  IX. 

"Accrued;"  defined,  60-61 

Accounts  payable;  controlling  ac- 
count, 111 

"Accounts  Payable;"  defined,  27 

"Accounts  Receivable;"  defined,  27 

Accounts  receivable;  controlling  ac- 
count, 111 

Administrative  expenses;  in  manu- 
facturing, 257 

Appreciation;  used  to  pay  dividends, 
222 

Articles  of  agreement;  partnership, 
89-90 

Assets;  classes  of,  209-12;  valua- 
tion of,  159-60 

Bad  debts;  accounting  for  losses 
from,  79-80;  nature  of,  78-79; 
practice,  Ch.  XII;  theory  of, 
Ch.  XI 


Balance  sheet,  Chs.  XXXII, 
XXXIII;  arrangement  of,  208; 
and  management,  273;  ex- 
plained and  illustrated,  41,  42; 
illustrated,  Ch.  XXXIII 

Bank  account;  use  of   114 

Bibliographies:  Corporation  Ac- 
counting, 188;  Expansion  of 
Accounting  Records,  144;  Fi- 
nancial Statements,  224;  Fun- 
damental Principles,  84^85; 
Partnership  Accounting,  104; 
Special  Applications  of  Princi- 
ples, 285 

Bondholders;  compared  with  stock- 
holders, 152 

Bonds;  advisability  of  issuing,  153; 
accounting  for  issues  of,  Ch. 
XXVI;  how  classified,  173; 
interest  on,  177-8;- issued  in 
perpetuity,  173;  marketing, 
167-8;  redemption  funds,  173- 
4;  redemption  of,  Ch.  XXVII; 
relation  to  stock,  151-2;  sold 
at  discount  or  premium,  168-9; 
sold  at  par,  168;  variations  in, 
153;  vs.  mortgages,  151-2 

Bookkeeping;  function  of,  22 

Budget;  preparation  of,  279 

Burden.     See  Indirect. 

Capital  account;  illustrated,  41 

Capital;  and  surplus,  212-13;  bonds 
paid  out  of,  173-5;  defined,  23; 
fixed,  defined,  70;  invested, 
nature  of,  69-70 

Capitalization;  factors  determining, 
161-2 

Capital  stock;  liability  on,  213;  pre- 
mium on,  used  to  pay  dividends, 
222 


297 


298 


INDEX 


Capital     stock     account;     use     of, 

180 
Capital;  working,  defined,  70 
Cash  book  or  journal;  function  of, 

14r-15 

Cash  discounts;  handling  of,  194 

"Cash;"  in  opening  entry,  26-27 

Cash  journal;  illustrated,  31,  46, 
48,  122,  234 

Cash;  petty,  Ch.  XVII 

Certificat-e,  stock;   defined,  148 

"Chalked  up;"  meaning  of,  9 

"Charge;"  meaning  of,  9 

Clearing  accounts;  depreciation  re- 
serves as,  76 

Closing  entries;  partnerhips  ac- 
counts, 96-97 

Columnar  journals,  Ch.  XVI;  illus- 
trated, 109 

Common  stock;  defined,  150 

Competition;  relation  to  accounts, 
3 

Controlling  accounts;  function  of, 
Ch.  XVI;  practice,  Ch.  XVIII 

Corporation  accounting,  Chs. 
XXIII,  XXIV,  XXV,  XXVI, 
XVII , 

Corporation;  accounting  for  bond 
issues,  Ch.  XXVI;  advantages 
of,  145;  defined,  145;  dividends, 
149;  open  and  close  147-148; 
opening  corporation  books,  Ch. 
XXIV;  opening  entry,  155-7; 
ownership  transferred,  148-149; 
possibilities  of  growth,  146; 
records  peculiar  to,  185;  re- 
demption of  bonds,  Ch.  XXVII 

"Cost;"  meaning  of,  251-53 

Cost  system;  advantages  of,  267-8 

Credit;  elements  in,  4 

"Credit,"  meaning  of,  10,  22;  rules 
for,  11 

Credit  System;  advantages  of,  8; 
relation  of  to  accounts,  4 

Cumulative  preferred  stock,   150 

Current  assets;  defined,  210 

'"Debit;"  meaning  of,  10,  22;  rules 

for,  11 
Deed  of  trust;  defined,  152 


Deferred  charges;  practice  work,  Ch. 
X;  defined,  211;  defined  and 
illustrated,  63-64;  theory  of, 
Ch.  IX;  wide  application  of 
theory  of,  64 

Deficit  account;  use  of,  180 

Delaware,  Lackawanna  &  Western; 
income  statement  of,  203 

Department  accounting,  Chs. 
XXXIV,  XXV;  purpose  of,  225 

Departments;  transfers  between,  229 

Depreciation ;  a  cause  of  bankruptcy, 
73;  and  bond  redemption,  176; 
and  efficiency,  78;  average  nor- 
mal, 78;  defined,  69;  effects  of, 
illustrated,  70-73;  practice,  Ch. 
XII 

Depreciation;  theory  of,  Ch.  XI 

Depreciation  reserves;  as  clearing 
accounts,  76;  growth  of,  76;  use 
of,  73-77 

Discount;  affects  profit  and  loss,  172; 
bonds  sold  at,  168-9 

Discount  on  purchases;  handling  of, 
194 

Dissolution;  partnership  accotint, 
97-99 

Dividend;  defined,  149,  183;  ac- 
counting for,  184;  and  surplus, 
183;  declaration  of,  183-4; 
kinds  of,  183;  profits  distribu- 
table as,  220-224;  relation  to 
profits,  149 

Economics;  relation  of  to  accounts, 

1,2 
Effective  interest  rate,  169-172 
Efficiency  and  depreciation,  78 
Errors;  location  of  facilitated,  111 
Executive;  reports  to,  3,  4 
Expense;    distinguished   from    loss, 

12-3;  significance  of,  23 

Final  trial  balance;  explained,  41, 
42 

Finished  goods;  transfers  to,  266 

Fixed  capital;  defined,  70 

Fixed  charges;  and  income  state- 
ment, 198 

"Folio;"  meaning  of,  21 


INDEX 


299 


Functional  classifications  of  trans- 
actions, 22;  illustrated,  Ch.  V 

Gains;  significance  of,  23;  how  ac- 
counted for,  15,  17 

General  expenses;  in  manufacturing, 
257 

General  journal;  illustrated,  45, 
48 

Goodwill;  in  incorporation,  159-60; 
in  partnership  accounts,  93, 
99-100;  in  partnerships  in- 
corporated, 160-1 

Graphic  charts,  Ch.  XLI 

Idle  machine  time,  261-63 

Imprest  system,  Ch.  XVII;  advan- 
tages of ,  117-118 

Imprest  system;  practice,  Ch.  XVIII 

Inadequacy; defined,  69 

Income  Statement,  Chs.  XXX, 
XXXI;  and  management,  273; 
contents  and  arrangement,  191- 
7;  illustrated,  42;  significance 
of,  198;  use  of,  191 

Incorporation;  advantages  of,  145; 
of  proprietorship  and  partner- 
ship, Ch.  XXV;  valuation  of 
assets,  159-60 

Indirect;  bases  of  prorating,  258; 
distribution  of,  227-8;  proration 
of,  257;  proration  by  machine 
rates,  260;  proration  on  basis  of 
prime  cost,  259;  proration  on 
basis  of  raw  materials,  258; 
proration  on  basis  of  direct 
labor,  258;  sources  of,  257; 
unapplied  charged  to  profit  and 
loss,  265 

Installments;  subscriptions  paid  in, 
158 

Interest;  as  an  accrual,  59-60;  de- 
fined, 59;  effective  rate,  169-172; 
on  bonds,  177-8;  on  partners' 
investments,  94-96;  on  sinking 
fund,  178-9 

Interest  accrued;  defined,  60-61;  on 
bonds,  178 

Interest  calculations;  discrepancies 
in,  170-1 


International     Mercantile     Marine 

Co. ;     accumulated     dividends, 

150 
Interpretation   of   ledger   accounts, 

Ch.  VI 
Inventories;  and  income  statement, 

198 
Inventory  (new);  significance  of,  37- 

38 
Inventory     (old);     significance    of, 

37-38 
Investments;  relation  to  accounts,  5 

Journal,  cash;  function  of,  14-15; 
columnar,  function  of,  Ch. 
XVI;  columnar,  illustrated, 
109;  function  of,  10,  16;  general, 
illustrated,  30;  illustrated,  233 
notes  payable,  112;  notes  re- 
ceivable, 112;  simple  form  of, 
9;  subdivision  of,  14 

Journal  entry;  opening,  24—25 

Labor;   accounting   procedure,    255 

Ledger  accounts;  interpretation  of, 
Ch.  VI 

Ledger;  function  of,  16;  illustrated, 
19-20,  25,  26,  32-34,  47;  in- 
terpretation of,  42 

Limited  liability,    146 

Loss;  distinguished  fiom  expense, 
12-13 

Losses;  how  accounted  for,  15,  17; 
significance  of,  23 

Management;  relation  of  to  ac- 
counts, 4;  relation  of  accounting 
to,  Ch.  XL 

Manager;  reports  to,  274 

Materials;  accounting  procedure, 
255;  purchase  of,  253 

Manufacturing  accounting,  Chs. 
XXXVI,  XXXVII,  XXXVIII 

Merchandise  account;  use  of,  38, 
note. 

Minute  book;  use  of,  185 

Mixed  accounts;  defined,  19; 'ex- 
plained, 37-38 

Net  profit;  disposition  of,  40-41 


300 


INDEX 


Net  sales;  importance  of,  197 
New   York,    New   Haven   «&   Hart- 
ford R.  R.  Co.;  considers  issue 
of  securities,  151 
Nominal  accounts;  defined,  18,  23; 
analysis  of,  27;  closing  of,  39; 
number  of,  27;  significance  of, 
19 
Normal  depreciation,  78 
Notes  payable  journal,  112 
Notes  receivable  journal,  112 

Obsolescence;  defined,  69 
Opening   entries;   for   partnerships, 

92-94 
Operating  ratio;  significance  of,  204 
Orders;  production  and  plant,  255 
"  Other  Income;"  meaning  of,  205 
Overhead.     See  Indirect. 

Partners;  admission  of,  99-100 

Partnership  accounting,  Chs.  XIII- 
XV;  practice,  Ch.  XV;  admis- 
sion of  partners,  99-100;  closing 
entries,  96-97;  bibliography, 
104;  dissolution,  97-99;  interest 
on  investments,  94-96;  opening 
entries,  92-94;  peculiarities  of, 
92;  theory  of,  Ch.  XIV 

Partnership  assets;  distribution  at 
dissolution,  91 

Partnership;  articles  of  agreement, 
89-90;  general  definitions  of, 
89;  incorporated,  Ch.  XXV; 
liability,  146;  limitations  of, 
145;  limited,  defined,  88;  pro- 
vision on  dissolution,  90-91 
dissolution,  caases  of,  91 

Partnership  form;  value  of,  87 
Partnerships  classified,  87 

Partnerships;  common  law,  defined, 
88 

Payroll;  accounting  procedure,  256 

Pennsylvania  R.  R.  Co.;  share- 
holders in,  148 

Percentages;  use  of,  274,  277 

Personal  service  corporations;  de- 
fined, 89 

Petty  cash,  Ch.  XVII 


Petty  cash  book;  illustrated,  116, 
122,  131 

"Posting;"  defined,  20 

Preferred  stock;  cumulative,  150; 
defined,  150 

Premium;  affects  profit  and  loss, 
172;  bonds  sold  at,  168-172 

Price-making;  problem  of,  275; 
relation  to  accounts,  3 

Private  ledger,  Ch.  XXI;  practice, 
Ch.  XXII 

Production;  modern  methods  des- 
cribed, 2 

Profit  and  loss  account;  explained, 
37-38;  illustrated,  40 

Profit  and  loss  statement;  illus- 
trated, 42 

Profit  and  loss;  subdivisions  of, 
27-28 

Profit;  net,  disp>osition  of,  40,  41; 
bonds  paid  out  of,  173-5;  how 
accounted  for,  15,  17;  how  as- 
certained and  distributed,  6; 
margin  of,  199;  need  of  re- 
serving, 200 

Promoter;  work  of,  155 

Proprietorship;  in  corporation,  212 

Purchases  account;  illustrated, 
37-39 

Purchases  journal;  illustrated,    107 

Raw  materials;  purchase  of,  253 

Real  account;  defined,  18,  23;  signi- 
ficance of,  19 

Record  of  subscriptions;  use  of, 
185 

Register  of  transfers;  use  of,  185 

Rent  expense  account;  illustrated, 
39 

Reports  to  executive;  in  Bethle- 
hem Steel  Co.,  3;  necessity  of, 
4 

Requisition;  use  of,  255 

Reserves;  depreciation,  use  of,  73-77 

Returned  purchases,   112 

Returned  sales,  112 

Sales  journal;  illustrated,  107 
Salaries  accrued;  illustrated,  62 


INDEX 


301 


Sales;  net,  importance  of,  197 

Selling  price;  profit  based  on,  275 

Single  entry;  no  nominal  accounts 
in,  19 

Sinking  fund;  and  bond  redemption, 
17&-7;  and  wasting  assets,  215; 
interest  on,  178-9 

Smith,  Adam,  on  division  of  labor, 
1 

Specialized  journals;  described,  Ch. 
XVI 

Specialized  ledgers;  described,    108 

Statement  of  assets  and  liabilities, 
160 

Statement  of  assets,  liabilities  and 
capital;  illustrated,  24 

Stock  authorized;   opening  entry, 
155-6 

Stock  certificate;  defined,  148 

Stock  certificate  book;  use  of,  185 

Stock;  common  vs.  preferred,  150 

Stock;  defined,  146;  factors  deter- 
mining values  of  150-151;  full- 
paid,  151 

Stockholder;  status  of,  147;  com- 
pared with  bondholders,  152 

Stock  ledger;  use  of,  185 

Stock  subscribed;  op>ening  entry, 
156-7 

Subordinate  ledgers;  function  of, 
Ch.  XVI 

Subscriptions;  payment  of,  157; 
payments  in  installments,  158; 
payments  other  than  cash,  157- 
8 

Supplementary  rate  plan,  261-64; 
criticism  of,  264-265 

Surplus  account;  illustrated,  181; 
use  of,  180 


Surplus,  and  capital,  212-13;  appro- 
priated, 182;  disposition  of, 
181-2;  sources  of,  182;  sub- 
division of,  182;  unappro- 
priated, 182 

Taxation;  relation  to  accounts,  5 

Transactions;  cash  and  credit,  8; 
functional  classification  of,  22; 
functional  classification  of,  illus- 
trated, Ch.  V;  recording  finan- 
cial, 20;  recording  financial,  Ch. 
II,  III;  recording,  practice, 
Ch.  VII,  VIII 

Trial  balance;  illustrated,  36;  na- 
ture and  purpose  of,  35-36; 
purpose  of,  37 

Trust  deed  (see  Deed  of  trust). 

Trustee;  sinking  fund,  177-179 

Trust  fund  theory,  213 

Turnover;  importance  of,   278-279 

United  States  Steel  Corp.;  income 
statement  of,  206;  shareholders 
in,  148 

Valuation;  relation  of  to  accounts,  5 

Valuation  Reserves;  practice,  Ch. 
XII;  theory  of,  Ch.  XI;  use  of 
73-77 

Voucher  register,  Ch.  XIX;  illus- 
trated, 235,  127,  134 

Voucher  register;  practice,  Ch.  XX 

Voucher  system,  126-128 

Wages  accrued;  illustrated,  62 
Wasting  assets;  treatment  of,  214-15 
Wear  and  tear;  defined,  69 
Working  assets;  defined,  210 
Working  capital;  defined,  70 


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